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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Markets Traded
equities

Financial instruments
stocks

Confidence in anomaly's validity
Moderately Strong

Backtest period from source paper
2002-2011

Notes to Confidence in Anomaly's Validity

Academic research papers show usually mixed evidence of the statistical significance of ESG factor strategies…


Indicative Performance
3.25%

Period of Rebalancing
Yearly

Notes to Indicative Performance

data from table 3, North America, the average of mean BHARs for Environment, Social and Governance scores


Notes to Period of Rebalancing

Estimated Volatility
0%

Number of Traded Instruments
1000

Notes to Estimated Volatility

not stated, however the results from bootstrap are significant at 1% level


Notes to Number of Traded Instruments

More or less, it depends on investor’s need for diversification


Maximum Drawdown
0%

Complexity Evaluation
Very complex strategy

Notes to Maximum drawdown

not stated


Notes to Complexity Evaluation

Sharpe Ratio
0

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 4×4 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

Not known - 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.

Source paper
Strategy's implementation in QuantConnect's framework (chart+statistics+code)
Other papers

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