We cannot deny that the high demand for climate-friendly assets may induce a crowding risk. However, it would be false to assert that there is an ESG bubble. Before delving into these issues, we have to precisely define the terms ‘financial crowding’ and ‘bubble’, as there could be some misunderstanding around these concepts.
First, we need to distinguish between crowding of trades and portfolios, because crowding of trades is more problematic than that of positions. The former case is generally characterised by high pairwise cross-correlation and low liquidity, whereas we observe time-correlation in the latter. In both cases, we notice an overvaluation with respect to the fair price, but it is not systematic.
Second, a financial bubble is characterised by a sharp rise in the market price of some assets. This situation is followed by a crash because investors understand that there is an imbalance between the fundamental value and the market value of these assets. A financial bubble has its origins in the mimetic behaviour of investors who want to participate in the market momentum, even if it is not supported by fundamentals. A typical example is the dot-com financial bubble at the end of the 1990s. The motivation behind these investments is then to generate large financial gains. However, when many investors seek to cash in on their potential profits, the asset bubble bursts. As such, a financial bubble implies a buying pressure followed by a selling pressure, and these imbalances are both motivated by momentum behaviours.
The case of ESG investing is different. ESG investors invest in some assets for extra-financial motivations and not exclusively for financial ones. ESG investors do not buy ESG-friendly assets with the motivation to sell these assets in the future if they do not perform. This is why we cannot compare ESG investing to value investing, momentum investing or quality investing. These last three investment styles are driven by financial considerations. ESG investing is a very different investment style since it is also motivated by moral values, ethics or responsible duties.
Furthermore, it is not certain that ESG investing can be characterized as an investment style per se. For instance, we cannot apply the concept of style rotation to ESG investing and it is unlikely that ESG investors will revert to being business-as-usual investors in the future. For instance, we observe value-growth, value-quality or contrarian-momentum rotation, but we never speak about ESG vs. non-ESG rotation3. Therefore, it is true that there is an ESG trend, but the existence of an ESG bubble is very much overestimated. As such, it is unlikely that we will see ESG investors revert, because this is more of a structural change in the financial market or a paradigm shift in the investment framework than a short-term trend. This is why it may take considerable time and equilibrium is still far away.