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On the one hand, corporate social performance can be interesting for socially responsible investors who seek responsible firms and their corresponding stocks. And therefore, their main motivation is not material. On the other hand, one branch of the financial literature examines the relationship between corporate social performance measured by the ESG scores and financial performance. ESG score stands for the Environmental, Social and Governance scores that are measured by various companies that unfortunately can sometimes provide mixed results since their methodology is not the same. Firstly, the environment score is a measure of environmental aspects such as emission reductions, low resource consumption and product innovations aiming at improving environmental protection. The social score measures customer and product responsibility and the aim for the "public welfare", for example, cash donations, protection of public health, business ethics, respect to health or diversity of the workforce, etc. Lastly, the governance score is a measure of behaviour concerning the board of directors, shareholder rights and the integration of fifinancial and non-financial goals of the company. The theory expects that in the short term, firms with high ESG scores would have abnormal returns of zero, but in the long run, theory expects positive abnormal returns. On the other hand, firms with low ESG scores are expected to have negative abnormal returns.
Additionally, results indicate that financial markets are inefficient in terms of ESG scores and are not capable of properly pricing different levels of corporate social performance in the short run and particularly in the long run. However, there are regional differences; paper examines regions of North America, Europe, Japan, and the Asia Pacific, and the best results are obtained for the North America region followed by Europe. The results for Japan and Asia are not as applicable as for the other regions. We will center our attention around the North America region and the possibility to utilize the aforementioned to build the ESG Level Factor Investing strategy by going long the stocks with high ESG scores and going short the stocks with low ESG scores.
Fundamental reason
Firstly, socially responsible investing is getting more and more popular among investors. Such popularity results in worldwide increasing amount of money invested by responsible investors either for profit or non-profit motives. Secondly, social responsibility can be often understood as a matter of sustainability. Therefore, the responsible firms, those with the high ESG scores, are connected with long-term perspectivity and prosperity. Since the market participants probably would not fully appreciate such activities by the firms until it becomes obvious from additional cash flows after making the change. Therefore, the best way to utilize the ESG scores is by doing it in the long run. Results prove that for Europe and North America, high ESG scores are connected with positive or zero abnormal returns over short investment horizons. Still, more importantly, such scores are connected with abnormal returns in the long run for all three scores - Environment, Social and Governance. According to the literature, socially responsible behaviour can prevent a firm from having to bear expensive fines imposed by the government, plus it can help to reduce a firm’s exposure to risk. Additionally, scoring high in those categories is connected with better management, the popularity of the firm and willingness of customers to pay more for the product (for example if the company is ecological, customers may be willing to pay more for the product). To sum it up, results show that a high corporate social performance at present, can, in the long run, save money and yield high cash flows that are not expected by the market.
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Market Factors
Confidence in Anomaly's Validity
Notes to Confidence in Anomaly's Validity
Period of Rebalancing
Number of Traded Instruments
Notes to Number of Traded Instruments
Complexity Evaluation
Financial instruments
Backtest period from source paper
Indicative Performance
Notes to Indicative Performance
Notes to Estimated Volatility
Notes to Maximum drawdown
Regions
Simple trading strategy
As we have previously mentioned, the choice of the database of ESG scores can alter results. This paper uses for the assessments of environment, social, and governance performance of single firms database provided by Asset4. Scores are updated every year, therefore to obtain monthly ESG data, the scores remain unchanged until the next assessment.
The investment universe consists of stocks of the North America region (Canada and the United States) that have ESG scores available. Stocks with a price of less than one USD are excluded. Paper examines the returns as abnormal returns according to the methodology of Daniel et al. (1997). Such methodology controls for risk factors such as size, book-to-market ratio, and momentum. The idea is to match a stock along with the mentioned factors to a benchmark portfolio that contains stocks with similar characteristics. Therefore, for the North America region, we have 4x4 benchmark portfolios. The abnormal return is calculated as the return of stock minus the return of stock´s matching benchmark portfolio return (equation 1, page 13).
Finally, each month stocks are ranked according to their E, S and G scores. Long top 20% stocks of each score and short the bottom 20% stocks of each score. Therefore, we have one complex strategy that consists of three individual strategies (for representative purposes; the paper examines each strategy individually). The strategy is equally-weighted: both stocks in the quintiles and individual strategies. The strategy is rebalanced yearly.
Hedge for stocks during bear markets
Unknown – Source and related research papers don't offer insight into the correlation structure of the proposed trading strategy to equity market risk; therefore, we do not know if this strategy can be used as a hedge/diversification during the time of market crisis.
Out-of-sample strategy's implementation/validation in QuantConnect's framework(chart, statistics & code)
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Source paper
Dorfleitner, Gregor and Utz, Sebastian and Wimmer, Maximilian: Where and When Does It Pay to Be Good? A Global Long-Term Analysis of ESG Investing
Abstract: This paper explores the long-term performance of stocks with high corporate social performance (CSP), measured by so-called ESG scores depicting the environmental (E), social (S), and governance (G) dimension. We investigate the buy-and-hold abnormal returns of a long/short investment strategy including the top and low 20% stocks with respect to each of the ESG dimensions. The results of the bootstrap tests in a world-wide perspective indicate that financial markets are not capable to price different levels of CSP in the short run and in particular in the long run properly. The zero investment strategy produces significantly positive abnormal returns up to 20% in North America and Europe in a five year period. We also identify regional differences, for instance, a high social score does not pay in Japan and strong corporate governance yields significantly negative abnormal returns in Asia Pacific.
Other papers
MELAS, NAGY, NISHIKAWA, LEE, GIESE: Foundations of ESG Investing – Part 1: How ESG Affects Equity Valuation, Risk and Performance
Abstract: Many studies have focused on the relationship between companies with strong ESG characteristics and corporate financial performance. However, these have often struggled to show that positive correlations — when produced — can in fact explain the behavior. This paper provides a link between ESG information and the valuation and performance of companies, both through their systematic risk profile (lower costs of capital and higher valuations) and their idiosyncratic risk profile (higher profitability and lower exposures to tail risk). The research suggests that changes in a company’s ESG characteristics may be a useful financial indicator. ESG ratings may also be suitable for integration into policy benchmarks and financial analyses.
Conen, Ralf, Hartmann, Stefan and Rudolf, Markus: Going Green Means Being in the Black
Abstract: We revisit the relationship between ESG and stock returns using a novel, monthly consensus rating for a global universe. Our results illustrate that how well or bad a firm does along the different dimensions of corporate social responsibility does affect the return of its shares. Fund managers constructing portfolios using information on a firms’ corporate social performance generally outperform, however may underperform in markets, where social responsibility is not as widely accepted. Secondly, excess performance of portfolios tilted towards corporate social responsibility is not always fully explained by the interaction with common risk factors such as value, size or momentum suggesting that ESG has a systematic effect on stock returns beyond those factors. This enables active fund managers to harvest risk-adjusted alpha. Thirdly, the effect of ESG on portfolio performance is asymmetric and does not appear to be constant over time. Fourth, markets reward short and longterm performance along ESG dimensions differently. Lastly, ESG is not a globally integrated factor. Rather it differs across regions with regard to direction, magnitude and statistical significance. We do not find a scenario in which investing in stocks with high ESG ratings leads to negative risk adjusted performance, suggesting that investors can greenwash portfolios without sacrificing performance.
Gougler, Arnaud and Utz, Sebastian, Factor Exposures and Diversification: Are Sustainably-Screened Portfolios Any Different?
Abstract: We analyze the performance, risk, and diversification characteristics of global screened and best-in-class equity portfolios constructed according to Inrate's sustainability ratings. The financial performance of sustainably high-rated portfolios is similar to the risk-adjusted market performance in terms of abnormal returns of a five-factor market model. In contrast, low-rated portfolios exhibit negative abnormal returns. Firms with high sustainability ratings show lower idiosyncratic risk, and higher exposure towards the high-minus-low and the conservative-minus-aggressive factor.
Abhayawansa, Subhash and Tyagi, Shailesh, Sustainable Investing: The Black Box of Environmental, Social and Governance (ESG) Ratings
Abstract: Environmental, social and governance (ESG) investing is becoming mainstream, and the COVID-19 pandemic has amplified the momentum. The interest in ESG investing has created greater demand for ESG data, ratings and rankings together with a proliferation of agencies offering these products which are unquestioningly relied on by investors, academics and regulators. Research highlights that different ESG ratings and rankings produce significantly different assessments of the ESG performance of companies. In this paper, we examine the causes of the differences in the ratings and ranking produced by different agencies. It is found that the divergences between raters can be attributed to differences in defining ESG constructs (i.e., theorisation problem) and methodological differences (i.e., commensurability problem). While users of ESG ratings and rankings are advised to study the definitions and methodologies prior to their use, lack of transparency about the data sources, weightings and methodologies makes it dificult to ensure that companies’ true ESG performance is accounted for when making portfolio selection and investment decisions. As a solution, we suggest that instead of attempting to compare and contrast ratings and rankings of different agencies, investors should determine ESG constructs material to their investment strategy and match them with an ESG ratings/rankings product that closely resemble those constructs.
Khajenouri, Daniel and Schmidt, Jacob H: Standard or Sustainable - Which Offers Better Performance for the Passive Investor?
Abstract: This research report studies the risk-adjusted performance of the major international equity indices against their ESG screened equivalents (MSCI World, MSCI USA, MSCI Emerging Markets, and MSCI Europe). The daily closing prices, returns, standard deviations, and Sharpe ratio characteristics are analyzed from 2013 to 2020. The current literature available from highly rated journals on the subject is also considered, which provided mixed results on the subject matter. We found no academic papers focusing specifically on analyzing the performance of indices and their ESG screened equivalents. With this paper, we intend to fill this gap in the current research available. We conclude that for the passive investor, choosing ESG screened indices over the conventional equivalent has consistently provided better risk-adjusted returns over the long-term period. These findings are robust with the consistently higher Sharpe ratios over the eight-year period for each index. We predict ESG investments may continue to outperform due to changing retail and institutional investor preferences.
Kang, Moonsoo and Viswanathan, Kalpathy G. and White, Nancy A and Zychowicz, Edward J.: Sustainability Efforts, Index Recognition, and Stock Performance
Abstract: We examine the long-term performance of stocks appearing in the Dow Jones Sustainability Index North America. We find that sustainability stocks exhibit abnormal returns for 12 to 30 months after the index listing while those stocks generate no excess returns before the index listing. Moreover, sustainability stocks experience an increase in institutional ownership after the index listing. However, we find no evidence that short sellers increase their position to exploit a possible overpricing for sustainability stocks. Overall, our analysis suggests that sustainability efforts translate into a permanent increase in demand for stocks, leading to the superior performance.
de Groot, Wilma and de Koning, Jan and van Winkel, Sebastian: Sustainable Voting Behavior of Asset Managers: Do They Walk the Walk?
Abstract: We investigate asset manager characteristics that influence ESG voting patterns using a decade of voting data with more than 20 million observations. Asset managers predominantly vote against social and environmental proposals. Especially, large and passive asset managers vote the least in favor of these proposals and despite the increased attention to sustainability integration, they hardly vote more in favor of these proposals than a decade ago. Moreover, signatories of the PRI do not vote more often in favor of environmental and social issues. Our results have important implications for investors striving for direct impact on the sustainability agenda of corporates.
Chen, Linquan and Chen, Yao and Kumar, Alok and Leung, Woon Sau, Firm-Level ESG News and Active Fund Management
Abstract: Using artificial intelligence and big data generated ESG news indices, we examine whether firm-level ESG news affects the investment choice of actively managed U.S. mutual funds. We find a positive relation between firm-level ESG news index and fund holdings. Fund managers incorporate ESG news to cater to investor demand and achieve higher risk-adjusted returns. Further, the ESG news-holding relation is stronger during periods of high ESG demand, and among funds located in Democratic states, with retail-oriented clienteles, better ESG ratings, higher marketing fees, and “domestic” fund managers. These results suggest that mutual fund managers successfully integrate ESG information into their portfolio decisions.
Faccini, Renato and Matin, Rastin and Skiadopoulos, George, Dissecting Climate Risks: Are they Reflected in Stock Prices?
Abstract: We construct novel proxies of physical and transition climate risks by conducting textual analysis of climate-change news over 2000-2018. This analysis uncovers four textual risk factors related to the topics of U.S. climate policy, international summits, natural disasters, and global warming, respectively. The first two factors proxy transition risks, whereas the last two proxy physical risks. We find that only the climate policy factor is priced in the U.S. stock market, with the evidence being more pronounced over 2012-2018. The documented positive premium is consistent with the argument that investors hedge short-term transition risks. We validate this explanation using a narrative approach to mark the content of climate news. Our results imply that investors' attention is an important driver of asset returns.
Chen, Qian and Liu, Xiao-Yang, Quantifying ESG Alpha in Scholar Big Data: An Automated Machine Learning Approach
Abstract: ESG (Environmental, social and governance) alpha strategy that makes sustainable investment has gained popularity among investors. The ESG fields of study in scholar big data is a valuable alternative data that reflects a company's long-term ESG commitment. However, it is considered a difficulty to quantitatively measure a company's ESG premium and its impact to the company's stock price using scholar big data. In this paper, we utilize ESG scholar data as alternative data to develop an automatic trading strategy and propose a practical machine learning approach to quantify the ESG premium of a company and capture the ESG alpha. First, we construct our ESG investment universe and apply feature engineering on the companies' ESG scholar data from the Microsoft Academic Graph database. Then, we train six complementary machine learning models using a combination of financial indicators and ESG scholar data features and employ an ensemble method to predict stock prices and automatically set up portfolio allocation. Finally, we manage our portfolio, trade and rebalance the portfolio allocation monthly using predicted stock prices. We backtest our ESG alpha strategy and compare its performance with benchmarks. The proposed ESG alpha strategy achieves a cumulative return of 2,154.4% during the backtesting period of ten years, which significantly outperforms the NASDAQ-100 index’s 397.4% and S&P 500’s 226.9%. The traditional financial indicators results in only 1,443.7%, thus our scholar data-based ESG alpha strategy is better at capturing ESG premium than traditional financial indicators.
Varmaz, Armin and Fieberg, Christian and Poddig, Thorsten, Portfolio optimization for sustainable investments
Abstract: Investments in firms related to environment, social responsibility and corporate governance (ESG) aspects have recently grown, attracting interest from both academic research and investment fund practice. This paper develops a simple new portfolio optimization approach to include ESG in portfolio formation. In addition to technical and practical advantages over a traditional mean--variance approach that incorporates ESG preferences, our approach allows us to follow competing explanations of the relation among risk, return and ESG. An extension of our portfolio optimization approach can even help distinguish competing explanations from the literature, i.e., between the preferences of investors for ESG firm characteristics and exposure to a common ESG risk factor. The proposed portfolio optimization approach is flexible enough to include additional risk factors and/or characteristics. We demonstrate the application of our approach to empirical data.
Schmidt, Anatoly B. and Zhang, Xu: Optimal ESG Portfolios: Which ESG Ratings to Use?
Abstract: The idea behind the optimal ESG portfolio (OESGP) is to expand the mean variance theory by adding the portfolio ESG value (PESGV) multiplied by the ESG strength parameter γ (which is investor’s choice) to the minimizing objective function (Pederson et al., 2019; Schmidt, 2020). PESGV is assumed to be the sum of portfolio constituents’ weighted ESG ratings that are offered by several providers. In this work we analyze the sensitivity of the OESGP based on the constituents of the Dow Jones Index to the ESG ratings provided by MSCI, S&P Global, and Sustainalytics. We describe discrepancies among various ESG ratings for the same securities and their effects on the OESGP performance. We found that the OESGP diversity decreases with growing γ. The dependence of the ESG tilted Sharpe ratio on γ may have two maximums. The 1st maximum exists at moderate values of γ and yields a moderately diversified OESGP. The 2nd maximum at large γ corresponds to a highly concentrated OESGP. It appears if portfolio has one or two securities with lucky combinations of high returns and high ESG ratings.
Gueant, Olivier and Peladan, Jean-Guillaume and Robert-Dautun, Alain and Tankov, Peter: Environmental transition alignment and portfolio performance
Abstract: We contribute to the debate on whether using ESG/SRI criteria in investment decisions improves portfolio performance. The choice of a specific ESG metric being crucial, we focus on the Net Environmental Contribution, a robust open-source measure of environmental transition alignment. From a universe of 752 European stocks, we select subsets of stocks with high and low NEC scores, and compare the performance of equal-weighted and capitalization-weighted portfolios constructed from these subsets over the 2015-2020 period. The high-NEC portfolios outperform the low-NEC ones consistently throughout the period, and particularly during 18 months starting mid-2019, both before and during the COVID crisis.
Jacob, Andrea and Wilkens, Marco: What drives sustainable indices? A framework for analyzing the sustainable index landscape
Abstract: This article presents an encompassing four-step customizable framework for analyzing the heterogeneous sustainable index landscape. Compared to previous studies, we present means and methods to move the measurement and impact of sustainability performance in the center of attention and emphasize the often neglected aim of sustainable indices: incorporating sustainability into investment tools. Besides traditional comparisons of return and risk indicators (step one), we analyze the sustainability profile of sustainable indices while actively managing the presence of ESG rating disagreement (step two). For the determination of index-specific return and risk sources, we integrate sustainability factors in factor analyses and risk decomposition approaches (step three). A performance attribution analysis based on sustainability classes increases the transparency on the composition strategies of sustainable indices (step four). Our framework facilitates the analyses of sustainable investment tools and thus supports investors in making more meaningful and forward-looking investment decisions in line with their sustainability-related preferences.
Amon, J.; Rammerstorfer, M.; Weinmayer, K. Passive ESG Portfolio Management — The Benchmark Strategy for Socially Responsible Investors
Abstract: In this article, we investigate the notion of doing well while doing good from the perspective of passive portfolio strategies. We analyze a number of asset allocation strategies based on ESGweighting and compare their financial and ESG performance for the US and Europe. We find no significant difference in the financial performance but superior ESG performance of ESG-based strategies. It can be concluded that, compared to a naive strategy, socially responsible investors are willing to pay a small premium for the impact of the portfolio via transaction costs when rebalancing the portfolio according to their preferences for social responsibility. In addition, when comparing the ESG-based strategies to a value-weighted strategy, we observe no significant difference in ESG performance but a high degree of significance in the superior financial performance of the ESG-based strategy. We also analyze the strategies with regards to the factor loadings given by the Fama–French five-factor model and a sixth factor denoted GMB (Good minus Bad) and find significant differences across the regions and strategies. Overall, the results show strong support of ESG-based strategies being preferred by socially responsible investors but also suggest that such strategies might be preferred by conventional investors looking for a passively managed alternative compared to a valueweighted index. Furthermore, it seems that such a strategy might be a more adequate benchmark for active SRI funds.
Berg, Florian and Kölbel, Julian and Pavlova, Anna and Rigobon, Roberto: ESG Confusion and Stock Returns: Tackling the Problem of Noise
Abstract: How strongly does ESG (environmental, social and governance) performance affect stock returns? Answering this question is difficult because existing measures of performance, ESG ratings, are noisy. To tackle the bias, we propose a noise-correction procedure, in which we instrument ESG ratings with ratings of other ESG rating agencies, as in the classical errors-in-variables problem. The corrected estimates demonstrate that the effect of ESG performance on stock returns is stronger than previously estimated; the standard regression estimates of ESG ratings' impact on stock returns are biased downward by about 60%. Our dataset includes scores of eight ESG rating agencies for firms located in North America, Europe, and Japan. We determine which agencies’ scores are valid instruments (not all of them are) and estimate the noise-to-signal ratio for each ESG rating agency (some of which are very large). Overall, our results suggest that it is advantageous to rely on several complementary ratings. In our sample, stocks with higher ESG performance have higher expected returns. Our model provides several explanations for this finding.
Larcker, David F. and Tayan, Brian and Watts, Edward: Seven Myths of ESG
Abstract: The trend to incorporate Environmental, Social, and Governance (ESG) matters into corporate boardrooms and capital markets is pervasive. Nevertheless, considerable uncertainty exists over what ESG is, how it should be implemented, and its financial and nonfinancial impacts on corporate outcomes and fund performance. In this Closer Look, we explore seven commonly accepted myths surrounding ESG, many of which are not supported by empirical evidence.We ask:• What is ESG expected to solve: short-termism by corporate managers or a deeper problem of corporations profiting at the expense of stakeholders?• Does ESG increase corporate value, or does it represent an incremental cost incurred for society?• How much ESG investment is new (incremental) investment, and how much repackaging of existing spending?• Why is governance included as the G in ESG?• Is it possible to develop a reliable measure of ESG quality?• Can standardized ESG reporting be done in an informative and cost-effective manner?
Crace, Logan and Gehman, Joel, What Really Explains ESG Performance? Disentangling the Asymmetrical Drivers of the Triple Bottom Line
Abstract: Why is there such great heterogeneity in environmental, social, and governance (ESG) performance between firms? Drawing inspiration from the locus of performance literature, we use variance partitioning methods to analyze the extent to which CEO, firm, industry, year, and state effects explain variation in ESG performance over recent decades. Our findings show that internal effects (i.e., CEO and firm) are the strongest determinants. Yet, disaggregation of the multidimensional ESG construct shifts the saliency of the factors significantly, revealing the importance of the external environment (i.e., industry and year) in explaining ESG concerns. Our research extends the locus of performance literature to our understanding of the triple bottom line and contributes to understanding the complex determinants of firm-level ESG performance across an array of positive and negative ESG indicators.
ten Bosch, Eline and Van Dijk, Mathijs A. and Schoenmaker, Dirk: Do the SDGs Affect Sovereign Bond Spreads? First Evidence
Abstract: <a href="https://papers.ssrn.com/sol3/papers.cfm?abstract_id=4006375">https://papers.ssrn.com/sol3/papers.cfm?abstract_id=4006375</a>We study the relation between a country's performance on the United Nations' Sustainable Development Goals (SDGs) and its sovereign bond spread. Using a novel country-level SDG measure for a global sample of countries, we find a significantly negative relation between SDG performance and credit default swap (CDS) spreads, while controlling for traditional macroeconomic factors. This effect is stronger for longer maturities, in line with the notion that the SDGs represent long-term objectives. The results are most consistent with perceived default risk driving this relation, rather than investor preferences. In sum, our initial evidence suggests that investing in the SDGs provides governments with financial benefits besides ecological and social welfare.
Han, Yingwei and Li, Ping and Wu, Sanmang: Does Green Bond Improve Portfolio Diversification? Evidence From China
Abstract: Green bonds are a type of fixed-income instrument that is specifically used to raise funds for projects with environmental benefits to mitigate and adapt to climate change. China's green bond market expanded rapidly in recent years due to national push for net-zero emissions and the growing appetite of investors. However, little is known about the investment benefits of green bonds from the perspective of portfolio optimization. This paper investigates whether green bonds offer better risk-return profile compared to conventional bonds in China. We compare the out-of-sample diversification benefits of green bonds and conventional bonds using various asset allocation strategies. The results show that the portfolio with green bonds leads to higher risk-adjusted returns than the portfolio with conventional bonds across different asset allocation strategies and risk aversions. This is mainly due to the increase in returns after including green bonds in the portfolio. Overall, our findings suggest that China's green bonds should be included in optimal portfolios.
Grim, Douglas and Renzi-Ricci, Giulio and Madamba, Anna: Asset Allocation with ESG Preferences: Efficiently Blending Value with Values
Abstract: The explosion of interest in ESG investing has yielded a number of quantitative frameworks that seek to incorporate non-pecuniary ESG preferences into conventional multi-asset portfolio optimization models. In this article, the authors specify an accessible approach that allows investors to simultaneously optimize for both pecuniary preferences (such as systematic, factor, and active risk aversion) and non-pecuniary ESG tastes in a way that avoids “one size fits all” solutions and arbitrary portfolio decisions. Using case studies, they find evidence that the strength of non-pecuniary desires along with both pecuniary expectations and risk preferences are important determinants of the optimal portfolio choice.
Dumitrescu, Ariadna and Zakriya, Mohammed and Jarvinen, Jesse: Hidden Gem or Fool's Gold: Can Passive ESG Etfs Outperform the Benchmarks?
Abstract: Using a unique and extensive dataset of 121 socially responsible investing (SRI) equity exchange-traded funds (ETFs) from January 2010 to December 2020, this study examines how passive SRI ETFs perform compared with their non-SRI benchmarks composed of S&P500 ETFs. Over the full sample period, our results show that an equally weighted SRI ETF portfolio underperforms its benchmark portfolio. Notably, we do not find significant differences in the two portfolios’ performance in the second half of our sample period. However, in the last two years, the SRI ETF portfolio significantly outperforms the benchmark. For the SRI investment strategies, we show that positive screening (or inclusion) rather than negative screening (or exclusion) can beat the benchmark portfolio. In particular, environmental inclusion screen provides significantly higher abnormal returns. Finally, we find that SRI ETFs’ performance can be explained by increasing industry competition and declining market concentration.
Varmaz, Armin and Fieberg, Christian and Poddig, Thorsten: Portfolio Optimization for Sustainable Investments
Abstract: In mean-variance portfolio optimization, factor models can accelerate computation, reduce input requirements, facilitate understanding and allow easy adjustment to changing conditions more effectively than full covariance matrix estimation. In this paper, we develop a factor model-based portfolio optimization approach that takes into account aspects of the environment, social responsibility and corporate governance (ESG). Investments in assets related to ESG have recently grown, attracting interest from both academic research and investment fund practice. Various literature strands in this area address the theoretical and empirical relation among return, risk and ESG. Our portfolio optimization approach is flexible enough to take these literature strands into account and does not require large-scale covariance matrix estimation. An extension of our approach even allows investors to empirically discriminate among the literature strands. A case study demonstrates the application of our portfolio optimization approach.
Çepni, Oğuzhan and Demirer, Riza and Pham, Linh and Rognone, Lavinia: Climate Uncertainty and Information Transmissions Across the Conventional and ESG Assets
Abstract: We examine the effect of climate uncertainty on the spillover effects across the European conventional and ESG financial markets via novel measures of physical and transitional climate risk proxies obtained from textual analysis. While the conventional stock market index serves as the net shock transmitter to ESG assets, we find that shock transmissions between the two asset classes are significantly lower during periods of high climate uncertainty, suggesting that ESG investments can offer conventional investors diversification benefits against climate-driven shocks. Indeed, by comparing a forward-looking investment strategy conditional on the level of climate risk to the passive investment strategy, we show that investors who are worried about physical climate risks could utilize ESG equity sector portfolios as a diversification tool during periods of high physical climate uncertainty. In contrast, ESG bonds are found to be particularly useful in managing transition risk exposures that are associated with policy uncertainty and/or business transitions with respect to environmental policies. The findings have important implications for investors and policymakers regarding the role of climate uncertainty as a driver of informational spillovers across the conventional and ESG assets with important insights to manage climate risk exposures.
Chasiotis, Ioannis and Gounopoulos, Dimitrios and Konstantios, Dimitrios and Patsika, Victoria: ESG Reputational Risk, Corporate Payouts and Firm Value
Abstract: This study identifies and empirically assesses the relationship between ESG reputational risk and corporate payouts. We provide robust evidence that ESG reputational risk stimulates higher payouts and that the presence of strong (weak) monitoring mechanisms amplifies (attenuates) this relationship. Turning to payout composition we show that ESG reputational risk steers firms towards a more flexible payout mix comprising a higher analogy of share repurchases versus dividends, an effect that intensifies under financial constraints. Moreover, we document that the market places a premium on distributions from high ESG reputational risk firms. Collectively, our findings indicate that ESG reputational risk raise financial risk thus firms respond by disgorging cash via a more flexible payout regime.
Capotă, Laura-Dona and Giuzio, Margherita and Kapadia, Sujit and Salakhova, Dilyara: Are Ethical and Green Investment Funds More Resilient?
Abstract: Funds with an environmental, social and corporate governance (ESG) mandate have been growing rapidly in recent years and received inflows also during periods of market turmoil, such as March 2020, in contrast to their non-ESG peers. This paper investigates whether investors in ESG funds react differently to past negative performance, making these funds less sensitive to short-term changes in returns. In the absence of an ESG-label, we define an ESG- or Environmentally-focused fund if its name contains relevant words. The results show that ESG/E equity and corporate bond funds exhibit a weaker flow-performance relationship compared to traditional funds in 2016-2020. This finding may reflect the longer-term investment horizon of ESG investors and their expectation of better risk-adjusted performance from ESG funds in the future. We also explore how the results vary across institutional and retail investors and how they depend on the liquidity of funds’ assets and wider market conditions. A weaker flow-performance relationship allows funds to provide a stable source of financing to the green transition and may reduce risks for financial stability, particularly during turmoil episodes.
Tham, Eric: Greenwashing Premium
Abstract: Greenwashing is framed as a signalling game between firms and investors and occurs due to cheap news signals. A worst social outcome occurs with a pooling equilibrium. Firms greenwashed if ex-ante they are in the top decile of a portfolio sorted by ESG news scores from NLP, and ex-post fell out from the top decile for ESG performance scores. The greenwashing premium for ESG in USA is historically not significant but episodic. The premium in 2020 was largely due to consumer and green firms at 2.9% and 4.2% respectively. It was larger for the ‘E’ and ‘G’ than the ‘S’ pillar, except amongst brown firms. A mechanism design is proposed to conceptually incentivise firms to keep to their ESG goals.
De Nard, Gianluca and Engle, Robert F. and Kelly, Bryan T.: Factor Mimicking Portfolios for Climate Risk
Abstract: We propose and implement a procedure to optimally hedge climate change risk. First, we construct climate risk indices through textual analysis of newspapers. Second, we present a new approach to compute factor mimicking portfolios to build climate risk hedge portfolios. The new mimicking portfolio approach is much more efficient than traditional sorting or maximum correlation approaches by taking into account new methodologies of estimating large-dimensional covariance matrices in short samples. In an extensive empirical out-of-sample performance test, we demonstrate the superior all-around performance delivering markedly higher and statistically significant alphas and betas with the climate risk indices.
Berg, Florian and Lo, Andrew W. and Rigobon, Roberto and Singh, Manish and Zhang, Ruixun: Quantifying the Returns of ESG Investing: An Empirical Analysis with Six ESG Metrics
Abstract: We quantify the financial performance of environmental, social, and governance (ESG) portfolios in the U.S., Europe, and Japan, based on data from six major ESG rating agencies. We document statistically significant excess returns in ESG portfolios from 2014 to 2020 in the U.S. and Japan. We propose several statistical and voting-based methods to aggregate individual ESG ratings, the latter based on the theory of social choice. We find that aggregating individual ESG ratings improves portfolio performance. In addition, we find that a portfolio based on Treynor-Black weights further improves the performance of ESG portfolios. Overall, these results suggest there is a significant signal in ESG rating scores that can be used for portfolio construction despite their noisy nature.
Juddoo, Kumari and Malki, Issam and Mathew, Sudha and Sivaprasad, Sheeja: An Impact Investment Strategy
Abstract: Impact investing is based on using the ESG framework as a tool to evaluate firms that engage in generating positive impact. Most impact investors and fund managers now integrate the ESG framework in their investment and stock-picking process. However, due to lack of standardisation of ESG reporting, it remains a challenge for investors and the public to identify the truly sustainable companies. We propose an additional measure of tax avoidance to identify firms that are socially responsible. When firms indulge in excessive tax avoidance behaviour, it may be viewed as unethical or socially irresponsible. We integrate the empirical association between corporate social responsibility and tax avoidance into an investment strategy based on impact. We adopt an investment strategy based on firm‐level ESG ratings and tax avoidance practices. In a pure impact investment strategy based on ESG and tax avoidance, we find that investing in high‐ESG rated firms and low tax avoidance firms yields a buy and hold abnormal return of 3.4% per annum and 11.4% in a 3 years investment horizon. Next, if impact investors were to combine traditional investment strategies based on risk with impact measures, we find that portfolios of high‐ESG and high price‐to‐book‐ratio firms earn a buy and hold abnormal return of 21.2%, while a portfolio of low tax avoidance and high price-to-book portfolios earns 29.8% in the long run. Collectively, our results suggest that, whilst impact investing does provide investors a return, it does not necessarily outperform traditional investment strategies. Our results are robust to other risk factors and the sector of the firm.
Institute for Monetary and Financial Research, Hong Kong: Doing Well by Doing Good? Risk, Return, and Environmental and Social Ratings
Abstract: We analyse the risk and return relationship of firms sorted by environmental and social (ES) ratings. We document that ES ratings do not have a statistically significant relationship with either average stock returns or unconditional market risk measures. Firms with high ES ratings have significantly lower downside risk than firms with lower ES ratings. However, a two standard-deviation move across stocks on ES score results in a decrease in downside risk measuring only 4–8% of the underlying downside risk measure’s standard deviation. This decrease in downside risk for high ES firms can be partly attributed to the news sentiment about the firms and institutional trading. Our results suggest that ES investing may not be justified solely based on the risk-return relationship of ES firms.
Karolyi, George Andrew and Wu, Ying and Xiong, Wei (William): Understanding the Global Equity Greenium
Abstract: We offer new evidence on how the application of environmental, social, and governance (ESG) criteria has affected international stock returns. We estimate the market-based equity greenium in a cross-section of 21,902 firms from 96 countries. We find reliable evidence that green stocks earned higher returns than brown stocks around the world. This outperformance is associated with lower stock returns of energy firms but not higher returns of technology stocks. Decomposing this outperformance further into five regions, including North America, Europe, Japan, Asia Pacific, and Emerging Markets, demonstrates that the equity greenium effect mostly occurs in North America and during the period before 2016. Most of the equity greenium performance cannot be explained by exposures to return factors prominent in the asset pricing literature.
Ai, Li and Silva Gao, Lucia: Investors’ Perception of Climate Risk: Evidence from Weather Disaster Events
Abstract: While climate change impacts most regions, a company’s physical location and geographical diversification could determine how it is affected by the risks associated with climate change. We explore information from extreme climate events to study if and how they impact firm-level risk. The results indicate a positive association between the level of a firm’s exposure to catastrophic climate events, measured based on the location of its headquarters and affiliations, and both systematic and idiosyncratic volatility, suggesting that this risk is to some extent unpredictable and undiversifiable. Furthermore, geographical dispersion and corporate diversification increase the exposure of firms to the risk of extreme climate events. Our results also indicate that this effect increases with investor awareness and is mitigated by better environmental performance of the firm. Overall, our research contributes to a better understanding of the exposure of businesses to risks associated with climate change.
Alves, Rómulo and Krueger, Philipp and van Dijk, Mathijs A.: Drawing Up the Bill: Are ESG Ratings Related to Stock Returns Around the World?
Abstract: We aim to provide the most comprehensive analysis to date of the relation between ESG ratings and stock returns, using 16,000+ stocks in 48 countries and seven different ESG rating providers. We find very little evidence that ESG ratings are related to global stock returns over 2001-2020. This finding obtains across different regions, time periods, ESG (sub)ratings, ESG momentum, ESG downgrades and upgrades, and best-in-class strategies. We further find little empirical support for prominent hypotheses from the literature on the role of ESG uncertainty and of country-level ESG social norms, ESG disclosure standards, and ESG regulations in shaping the relation between ESG and global stock returns. Overall, our results suggest that ESG investing did not systematically affect investment performance during the past two decades.
Torricelli, Costanza and Bertelli, Beatrice: The Trade-Off between ESG Screening and Portfolio Diversification in the Short and in the Long Run
Abstract: This paper investigates the performance of portfolio screening strategies based on ESG (Environmental, Social, Governance) scores, by testing three main hypotheses motivated by introducing Corporate Social Responsibility (CSR) considerations within portfolio theory: i) ESG screened portfolios with low exclusion thresholds overperform the benchmark in the long term; ii) ESG screened portfolios do not overperform the benchmark in the short term independently of the screening threshold and the phase of the economic cycle; iii) ESG screened portfolios have lower systemic risk compared to the benchmark. To this end, negative and positive screening strategies based on Bloomberg ESG disclosure scores and different screening thresholds are set up from the 559 stocks belonging to the EURO STOXX index in the period 2007-2021 and over four short-term subperiods including two crises (2008 global recession and 2020 Covid-19 pandemic). The risk-adjusted performance of the ESG screened portfolios is compared with the benchmark-passive one based on Sharpe Ratio and alphas (from both a one-factor model and the Carhart four-factor model) so as to test performance over total and systemic risk respectively. Three main results emerge. First, we prove overperformance of screened portfolios in the long run only and in the presence of negative screening strategies. Second, we show no overperformance in the short run even in period of financial crises thus contesting the alleged safe-haven property of ESG portfolios. Finally, comparative performance of ESG screened portfolios with respect to the benchmark passive strategy does not improve when we consider a measure of systemic risk.
Iwata, Tsuyoshi and Weibel, Marc: Enhancing Equity Factor Model with Publicly-reported ESG Data
Abstract: This study examines the alpha-generating power of the public-report-based ESG score, which is based on ESG incident data collected by RepRisk from various public sources, and its relationship with the self-disclosure-based ESG score obtained from Refinitiv. We construct pure ESG factor portfolios to neutralize exposure to common style factors and isolate the pure ESG factor returns. Our results suggest that (i) the source difference is the main cause of the negative correlation between the public report ESG and the self-disclosure ESG score, (ii) the public report ESG score and its subscores produce the mixed results in terms of their adjusted factor returns across regions, (iii) the combination of the public report ESG and the self-disclosure ESG score significantly improves the risk-return profiles of the combined ESG factor returns in the US, EU and Japan.
Kolle, Janina and Lohre, Harald and Radatz, Erhard and Rother, Carsten: Factor Investing in Paris: Managing Climate Change Risk in Portfolio Construction
Abstract: The 2015 Paris Agreement is a landmark in limiting emissions and targeting global warming well below 2, preferably 1.5, degrees Celsius compared to pre-industrial levels. In this light, we investigate how to efficiently construct equity portfolios that help mitigating climate change risk but at the same time enable harvesting well-established return drivers such as value, momentum or quality. A pure reduction in greenhouse gas intensity or a divestment from fossil sectors is not necessarily leading to a better temperature alignment of a portfolio. Given the limited set of temperature-aligned assets, keeping the average temperature increase below 2 degrees comes with considerable active risks. To this end, we propose a net zero portfolio construction framework that brings temperature alignment together with a reduction in carbon intensity, while harvesting equity factor premia.
Tan, Yeng-May and Szulczyk, Kenneth R and Sii, Yew-Hei: Performance of ESG-Integrated Smart Beta Strategies in Asia-Pacific Stock Markets
Abstract: Environmental, Social, and Governance (ESG) investing is about ethical investing. While ESG investing has garnered heightened attention, the research has not settled on whether ESG investing can “do well while doing good”. Using a proprietary ESG rating database of monthly firm-specific data, we examine the performance of ESG-incorporated investing strategies in Australia, Mainland China, Hong Kong, Malaysia, and Singapore. Specifically, we combine positive screening and the smart beta approach to evaluate the performance of ESG-based and non-ESG-based (traditional) equity portfolios. Our key findings reveal that high-ESG-based portfolios do not offer superior risk-adjusted returns compared to the low-rated portfolios. While a high-ESG-rated portfolio generally outperforms the market index, the ESG and traditional smart beta alphas differ little. Our results also indicate that the minimum-volatility portfolio achieves the best performance of all the factors. We use data from Refinitiv ESG and Bloomberg ESG to substantiate and support the results. Our findings add to the growing ESG literature that answers whether investors risk sacrificing returns while investing ethically.
Mahmood, Atif and Mehmood, Asad and Terzani, Simone and De Luca, Francesco and Djajadikerta, Hadrian Geri: ESG Performance and Firm Value: Evidence from Eu-Listed Firms
Abstract: We investigate how environmental, social, and governance (ESG) performance affects firm value. We consider listed firms in EU countries and extract panel data from the Bloomberg database from 2012 to 2021. Our final sample comprises 976 firms from 26 EU countries with 11 industry sectors. We apply the ordinary least squares technique to analyse the data. The results show that ESG performance positively and significantly influences firm value. It represents that ESG issues are relevant to stakeholders’ concerns, and addressing such issues increases firm value. This study provides important implications for practitioners and stakeholders.
Gao, Yumeng and Herbert, Benjamin and Melin, Lionel: The ESG Disclosure Premium
Abstract: Do firms benefit from reporting sustainability information? This paper finds that firms that initiate disclosure of ESG metrics enjoy higher equity valuation today. Disclosing on any of the eight key environmental and social quantitative measures that we identify in this paper lowers firms' cost of equity. The positive disclosure premium has increased over time and even turned from negative to positive in North America and emerging markets in particular after the 2015 Paris Agreement. Differentiated rewards for disclosure initiation are identified across sectors, while current disclosure achievements -or lack thereof- are reported. This paper identifies a substantial room for progress in particular in emerging markets and less carbon-intensive sectors. This mapping points to areas of potentially fruitful engagement between firms and investors that would benefit all stakeholders.