ESG: What is Under the Hood?

Residual Returns from ESG Investing

July 2019. Reading Time: 10 Minutes. Author: Nicolas Rabener.

SUMMARY

  • The ESG factor generated positive returns since 2011
  • Strong sector biases (long tech & short discretionary) explain the performance
  • Residual returns from ESG investing are essentially zero

INTRODUCTION

Investing is complicated as it is simple and complex at the same time. Common advice for new investors is to pursue a buy-and-hold approach for long-term wealth creation. Although this strategy has worked out great in the U.S. stock market, it has been far less attractive for Japanese or Chinese investors, casting doubt on this simple recommendation.

Millennials are especially interested in investment products that feature high environmental, social, and governance (ESG) standards. It should be simple to distinguish between good and bad companies. Investors might assume that oil stocks like BP rank low on ESG metrics while electric car makers like Tesla rank high, until they learn that electric batteries require cobalt, which is mainly mined in the Democratic Republic of Congo, a country where children are frequently employed. ESG investing is more complex than it might seem.

Investors considering ESG strategies should also question if there is a price to pay for investing in stocks with high ESG scores as there are very few free lunches in finance. Companies that rank high on ESG metrics need to be good corporate citizens in their local communities, treat their employees well, not pollute the environment, and show sound governance standards. Not all of this might be in the interests of shareholders, which mostly care about profits, dividends, and share buybacks.

In this short research note, we will analyze the performance of ESG investing in the U.S. stock market. Specifically, we focus on the pure ESG factor where we reduce the exposure to sectors and other common equity factors in order to highlight the residual returns from ESG investing.

GOOD VERSUS BAD CORPORATES

We utilize data from a U.S. provider that aggregates ESG scores from multiple other providers, which results in a comprehensive data set that covers most of the stocks listed in the U.S. stock market. We create a beta-neutral long-short portfolio composed of the top and bottom 10% of U.S. stocks sorted by ESG metrics, which comp