ESG Preference and Market Efficiency: Evidence from Mispricing and Institutional Trading

This paper documents that the uprising ESG investing constitutes a new “friction” for stock market efficiency after 2003. Socially responsible institutions underreact to mispricing signals when trading according to mispricing prescriptions is against their preference for ESG performance, further leading to return predictability. Specifically, most underpriced stocks with poor ESG performance have the highest risk adjusted returns, while most overpriced stocks with good ESG performance have the lowest risk adjusted returns. We rule out alternatives, such as known limits to arbitrage or difference in investment horizon. The inefficiency is not fully offset by ESG-neutral arbitrageurs due to funding liquidity constraints. † We thank Vikas Agrawal, Hendrik Bessembinder, Jennifer Carpenter, Tarun Chordia, Zhi Da, Amit Goyal, Daniel Giamouridis, Charlie Hadlock, Bing Han, Samuel Hartzmark, Michael Hertzel, Jason Hsu, Gang Hu, Zoran Ivkovich, Hao Jiang, Kose John, Ralph Koijen, Dong Lou, Jeffrey Pontiff, Florian Scheuer, Alexi Savov, Esad Smajlbegovic, David Solomon, Boris Vallee, Patrick Verwijmeren, Neng Wang, Robert Whitelaw, Jeffery Wurgler, David Yermack, and seminar participants at China Institute of Finance and Capital Markets, Erasmus University Rotterdam, The Chinese University of Hong Kong, Hong Kong Polytechnic University, Korea University, NYU Stern, Michigan State University, Northeastern University, Shanghai Jiaotong University, Shanghai School of Finance and Economics, and Tsinghua University for helpful discussions and useful suggestions. We have benefited from the comments of participants at the 2017 CQAsia-BoAML Conference (Hong Kong), the 5th Deutsche Bank Annual Global Quantitative Strategy Conference (New York), and INQUIRE Europe Autumn Seminar (Budapest). All errors are our own. ESG Preference and Market Efficiency: Evidence from Mispricing and Institutional Trading