Establishing a relationship
Researching the relationship between ESG ratings and stock returns, volatility and risk-adjusted returns since the 2008 financial crisis, we found that higher return companies in aggregate had better ESG ratings, but that there was a stronger (negative) correlation between ESG ratings and stock volatility, and this relationship was even stronger when market volatility was higher. The results held after controlling for sectors. The correlation between ESG rating and risk-adjusted return turned significantly positive in recent years, and this positive correlation strengthened further by removing the lowest-rated stocks.
The negative relationship between ESG and volatility was explored in greater depth, given the well-documented low volatility anomaly (outperformance of low volatility stocks). Chi-square frequency tests – used to evaluate whether to reject or fail to reject a statistical hypothesis – showed that stocks rated high on ESG tended to be in the low volatility group, and vice versa, and that the ESG rating had an impact independent of the low volatility effect.
Deleting the lower tail of ESG-ranked companies did not harm portfolio returns (including risk-adjusted), tending to improve the probability distribution of returns with a higher average and higher maximum.
Integrating into investment process
We integrate ESG research within the investment team and research reports, which include an ESG section to be completed by each investment analyst.
Our investment process starts by using a proprietary valuation model to compute expected returns for equities. A research universe is created of the highest expected return stocks, which are then analysed using traditional fundamental analysis techniques (market share and competitive analysis; financial analysis and valuation analysis). Within the final stage, ESG research informs the portfolio construction process to adjust the weights of poor ESG-rated stocks to zero for all portfolios.
Investment decision impact
Kroger is a fundamentally attractive-looking supermarket chain, with a PE ratio around the levels of its peer group but a much higher return on equity (ROE), along with a solid balance sheet and a history of consistently beating estimates. Looking past those numbers, however, a number of ESG-related controversies raise concerns, including health and safety issues, supply chain labour standards, and an incident involving faulty reimbursem*nt claims that resulted in a fine. Some of its stores also sell firearms, which is an issue for many investors. When passing through our portfolio construction process, these issues caused the weight of the stock to be reduced to, zero leaving it out of our ESG portfolio.
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A practical guide to ESG integration for equity investing
September 2016
FAQs
ESG performance and investment performance
However, while still positive, the link between ESG and overall portfolio returns was less robust. Sustainability data positively influenced portfolio returns in 38% of cases, while a negative influence was found only 13% of the time (see Figure 1).
Is there a correlation between ESG ratings and financial performance? ›
H1 posits that an increase in ESG performance leads to improved corporate financial performance. The results support this hypothesis, in that ESG performance has a significant and positive effect on ROA (α = 0.894, p < 0.01), indicating that high ESG performance leads to better financial performance.
What is the main criticism towards ESG ratings? ›
The way it's measured isn't standardised
However, while there have been calls to standardise ESG scores, this itself has sparked concerns that it would leave the measurements prone to manipulation, meaning a universal ESG rating system may not be the solution.
Does the ESG index affect stock return? ›
A fixed effect model based on a panel unbalanced data of listed companies in China from 2011 to 2020 is selected for the empirical analysis. The results show that ESG performance of listed companies in China positively impacts stock returns.
What is the link between ESG and profitability? ›
We find that ESG performance has a positive and highly significant relationship with firm value and profitability with a coefficient of 0.008 and 0.049 respectively. These findings provide evidence for corporate managers to justify mobilizing more resources for ESG.
Does ESG lead to higher returns? ›
ESG does not really provide a positive risk premium, but rather a negative risk premium, once the performance is explained by the various risk factors and investment sectors. However, ESG can generate positive returns in certain conditions, using ESG momentum.
How accurate are ESG ratings? ›
ESG ratings are not predictive
ESG ratings don't always accurately predict the ESG risks faced by a company. Many ESG rating agencies imply that their reports can provide an indication of a company's future ESG risk, however, recent studies show that they're not reliably predictive.
What is the bias of ESG scores? ›
One common media myth is that ESG ratings are biased and politically motivated, leading to unfair assessments of companies. While it's true that some ESG rating providers may have their own biases, the broader ESG rating framework is designed to be objective, and data driven.
What is the difference between ESG scores and ratings? ›
ESG “score” and ESG “rating” are used often interchangeably. A key difference lies in the use of numerical scores and letter ratings, which differs between rating agencies. For example, MSCI uses letter ratings ranging from CCC (Laggard) to AAA (Leader). ISS uses numerical scores ranging from 1 (best) to 10 (worst).
What is the biggest ESG scandal? ›
In December 2022, Florida announced that it was taking $2 billion out of the management of BlackRock, the world's largest asset manager (and biggest lightning rod for ESG criticism). This was the largest such divestment thus far. These attacks have been coordinated.
Additionally, some critics have raised concerns about the complexity and reliability of ESG metrics. But much of the backlash is driven by the perception that ESG criteria are biased against certain industries like oil and gas. Critics argue fund managers are prioritizing political goals over generating returns.
Why are people against ESG? ›
Some opponents also believe that ESG investing is politically motivated and could lead to biased investment decisions.” In a line used by proponents, those in opposition to the ESG movement also believe there is substantial support behind them.
Do investors care about ESG ratings? ›
From a financial materiality standpoint, investors are concerned with how ESG factors can affect a company's financial condition and operational performance.
Do investors really care about ESG? ›
Retail investors do care a lot about the ESG-related activities of the firms they invest in, but only to the extent that they impact firm performance, independent of ESG performance.
Does ESG outperform the market? ›
In some cases, ESG has outperformed, while in others, it has underperformed. Figuring out whether ESG stocks outperform the broader market is difficult for a few reasons. For one, there isn't a central authority that can decide whether a business follows ESG practices.
What are the average returns for ESG investing? ›
Globally, ESG Leaders earned an average annual return of 12.9%, compared to an average 8.6% annual return earned by Laggard companies. This represents an approximately 50% premium in terms of relative performance by top-rated ESG companies.
What is the correlation between solid ESG reporting and the stock market? ›
In reviewing over 1,000 studies published between 2015 – 2020, we found a positive relationship between ESG and financial performance for 58% of the “corporate” studies focused on operational metric such as ROE, ROA, or stock price with 13% showing neutral impact, 21% mixed results (the same study finding a positive, ...
Does ESG investing deliver superior financial returns? ›
While the specific impact of ESG factors on financial returns may vary across studies and market conditions, there is a growing body of evidence suggesting a positive correlation between strong ESG practices and financial outperformance.
What is ESG and how does it relate to investing? ›
This type of ethical investing strategy helps people align investment choices with personal values. ESG stands for environment, social and governance. ESG investors aim to buy the shares of companies that have demonstrated a willingness to improve their performance in these three areas.
