ESG Factor Momentum Strategy

Fundamental reason

Socially responsible investing is getting more and more popular among investors. The increased attention leads to an increasing worldwide amount of money invested by responsible investors either for profit or non-profit motives. The main idea of the paper is simple. The research hypothesizes that firms which have improved the ESG the most are expected to outperform other firms. One possibility is to look at the level of ESG scores. Still, the advantages of a better-rated ESG portfolio are expected to be apparent only in the long term, for example, because of increased cash flows. On the other hand, the momentum compares the rise of the ESG scores. According to the paper, it is expected that the market could react to a change in rating in a relatively short time period. Therefore, the high ESG momentum stocks should be outperforming lower ESG stocks. Moreover, the lowest ESG stocks should underperform.

Simple trading strategy

The investment universe consists of stocks in the MSCI World Index. Paper uses MSCI ESG Ratings as the ESG database. The ESG Momentum strategy is built by overweighting, relative to the MSCI World Index, companies that increased their ESG ratings most during the recent past and underweight those with decreased ESG ratings, where the increases and decreases are based on a 12-month ESG momentum. The paper uses the Barra Global Equity Model (GEM3) for portfolio construction with constraints that can be found in Appendix 2. Therefore, this strategy is very specific, but we aim to present the idea, not the portfolio construction. The strategy is rebalanced monthly.

Out-of-sample strategy's implementation/validation in QuantConnect's framework(chart, statistics & code)

Source paper

Zoltán Nagy, Altaf Kassam, Linda-Eling Lee: CAN ESG ADD ALPHA?

Abstract: Do institutional investors sacrifice risk-adjusted returns by incorporating environmental, social, and corporate governance (ESG) considerations? The authors analyze two relatively hightracking-error global strategies constructed using ESG data—a tilt strategy and a momentum strategy and find that both model portfolios outperformed the MSCI World Index over the past eight years, while also improving the ESG profile of the portfolios. These backtested model portfolios provide an example of how institutional investors with the tolerance to take some active risk, while at the same time looking to improve the ESG profile of their portfolios on a systematic basis, can incorporate such strategies in their investment processes.

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.

• Antoncic, Madelyn and Bekaert, Geert and Rothenberg, Richard V and Noguer, Miquel: Sustainable Investment - Exploring the Linkage between Alpha, ESG, and SDG's

  Abstract: Environmental, Social and Governance (ESG) investing has been one of the most important trends in the asset management industry over the past decade. Previously institutional asset owners believed that ESG issues, also known as nonfinancial risks and opportunities, were not relevant to portfolio value and therefore were nonessential, or even in conflict with their fiduciary duties to act in the best interest of their beneficiaries. In this paper, we analyze the relationship between alpha generation and ESG metrics. We also measure whether companies have an either positive or negative net influence on the U.N.’s Sustainable Development Goals (SDG´s) which are emerging as the new, broader standard to measure sustainability. First, we explore whether utilizing ESG factors can improve performance vis a vis the MSCI US index. By constructing a sector-neutral portfolio using MSCI ESG momentum scores from 2013 to 2018, we determine that it is feasible to generate positive alpha from an ESG momentum strategy. Second, we utilize structured and unstructured data to determine a company’s net influence on the SDGs, or what we call its SDG ‘footprint.’ Our research shows that an ESG momentum portfolio not only outperforms the MSCI US index but has a relatively better SDG footprint than that of the index. Third, we establish a positive contemporaneous connection between the sample portfolio’s ESG ratings change (its momentum) and its coinciding SDG footprint over the sample period. We conclude that a positive linkage exists between ESG, alpha, and the SDG’s.

• 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.

• Latino, Carmelo and Pelizzon, Loriana and Rzeźnik, Aleksandra, The Power of ESG Ratings on Stock Markets

  Abstract: This paper studies the impact of environmental, social, and governance (ESG) ratings on investors’ preferences and stock prices. We exploit a change in ESG rating methodology that non-linearly shifted ESG ratings for firms as a natural experiment. We show that the ‘pseudo’-changes in the ESG ratings induced by the change in methodology are unrelated to potential fundamental changes in firm’s sustainability. Yet, we find that an exogenous change in a stock’s ESG rating exerts a transitory price pressure and alters the composition of stock ownership. Individual investors are especially sensitive to the ‘pseudo’-changes in the ESG ratings. They (dis)invest in stocks that they misconceive as ESG (down-) upgraded. Short sellers act as arbitrageurs and take the other side of retail investors’ trades. Overall, we find that a one standard deviation quasi-increase in the ESG ratings translates into 1pp drop in stock monthly abnormal return.

• 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?

• Ma, Yuanfang and McLoughlin, Nicholas: ESG Momentum in Regional Equity Markets

  Abstract: This article investigates the use of ESG metrics for asset allocation decisions. We analyse a basic active allocation strategy within regional equity markets, assessing the usefulness of ESG information via two dimensions: the impact on active returns and the predictability of future ESG scores. Our results suggest tilting portfolios on the basis of ESG information can enhance both portfolio returns and future portfolio ESG scores.

• 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.

• 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.

• 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.