Is It Good to Be Bad? – The Quest for Understanding Sin vs. ESG Investing

ESG investing is a dynamic trend in portfolio management that centers on a company’s Environmental, Social, and Governance (ESG) scores, reflecting their commitments to environmental responsibility, social practices, and governance attributes. As ESG investing gains popularity, it transforms from a niche strategy to a mainstream investment approach, profoundly influencing capital allocation and corporate practices.

But what are our expectations from the ESG theme on the portfolio management level? The question is whether ESG investing also offers some kind of “alternative alpha”, or outperformance against the traditional benchmarks. There are managers and academics who are enthusiastic and hope for the outperformance of the good ESG stocks. However, the academic research community is really split. Some academic papers show positive alpha for “Saints” (good ESG stocks); others show significantly positive alpha for “Sinners” (bad ESG stocks). 

So, how it’s in reality? Is it “Good to be Bad”? Or the other way around?

Our task of finding answers to those questions is further complicated by the fact that there is no consensus on how to measure the ESG scores among rating agencies. ESG grading is notoriously fuzzy, and different agencies often grade one company differently, impeding the accurate assessment of a company’s sustainability performance. Therefore, we decided to avoid the problem of ESG scoring among stocks and concentrated our attention on investment vehicles that self-report their investment theme – pro-ESG vs. anti-ESG Exchange Trading Funds.

We used the Expanded ETF Taxonomy offered by ETF Global, identified ETFs with a relevant theme, and studied a diversified portfolio of ETFs. By diversifying among multiple ETFs with the same style, our approach to studying thematic ETF portfolios allows us to bypass the problem of inconsistent ESG grading among providers. Individual decisions of managers of ETFs about which scoring provider they use are averaged out in a portfolio of ETFs with the same style. This approach allows us to better assess which investment style is the ultimate winner – the pro-ESG funds (Saints) or anti-ESG funds (Sinners).

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