ESG’s evolving performance: First, do no harm

We recently looked at the investment performance of ESG, paying particular attention to recent performance and highlighting the difference between ESG scores that overlap with traditional risk model factors and those that don’t. What I found is that, in general, increasing exposure to ESG rarely underperforms the market, and often outperforms the market, especially during the last few years.

Reporting of ESG metrics is on the rise
Environmental, social and governance (ESG) data availability, marketing presence and regulation have increased dramatically in the last few years. As recently as 2011, only 20% of the companies in the S&P 500 Index even reported ESG metrics; the percentage is now over 80% (1). Recent regulatory and policy changes have been made to either directly or indirectly support ESG investing (2).

Given these marked changes, a natural question to ask is: how has ESG performance changed? Since these changes have occurred over a relatively short period of time, one cannot expect to answer this question with much statistical significance, nor can one say much about long term performance. Nevertheless, as more portfolio managers (PMs) consider adding ESG to their portfolio construction process, data on recent performance and how it compares with the past is likely to be of value.

A second question for PMs is to what extent are ESG scores different from the factors found in commercial fundamental factor risk models, such as value, size, industries and countries? The answer to this question informs portfolio managers on how incorporating ESG into their portfolio construction process may interact with their existing goals and mandates. To the extent that ESG scores overlap with traditional factors, then ESG can be interpreted as beta (“smart beta” to the marketers); to the extent these scores do not overlap with traditional factors, then ESG can be interpreted as residual, idiosyncratic or company specific (“alpha” to the quants).

Mind the overlap with traditional risk model factors
On the one hand, some of the key drivers of ESG are industries or industry-based. Companies that produce and sell tobacco, alcohol, and weapons, along with gambling businesses, are normally assigned low S scores. Utilities typically have a higher weight on E than banking or pharmaceutical companies. These traditional risk model factors (industries) are an inherent part of the definition of ESG, so overlap is inevitable.

On the other hand, some ESG drivers are company specific. For example, the number of women in a company’s corporate structure and corporate pay and tax transparency are both components of the G score that can be altered by a company at its discretion. Hence, these are company-specific ESG decisions. Of course, if several competing companies increase the number of women on their boards at the same time, those independent decisions may be less company specific than anticipated.Mathematically, the overlap can be estimated by regressing ESG scores against traditional risk model factors. The R-squared (percent variance explained) of each regression varies from 15% to 75% depending on the universe and methodology, indicating that there is substantial but not full overlap.

Let us look at three different ESG scores investors can potentially focus on:

• Raw ESG = the original ESG scores;
• Factor ESG = the part of the original ESG score that overlaps with a set of risk model factors; and,
• Residual ESG = the part of the original ESG score that does not overlap with a set of risk model factors.

The existing ESG literature is largely biased in favor of the Residual ESG. In some cases, this bias is explicit: “ESG cannot be regarded as a traditional factor.” (3) In other cases, the bias is implied. MSCI provides industry-adjusted ESG scores for example. In some studies, these industry- adjusted ESG scores are further neutralised with respect to size (4). RobecoSAM’s Smart ESG scores “isolate the ESG factor by removing the biases” (e.g., size and quality) (5). These selective neutralisations change a raw ESG score that may overlap with other well-known factors, into a Residual (or partially residual) ESG score.

Risk reduction and performance gains

Diversification likely drives some of the bias toward Residual ESG. Indeed, Residual ESG returns are more likely to be uncorrelated with market returns, and therefore can diversify a portfolio (e.g., reduce portfolio risk). However, Factor ESG is expected to be a less effective diversifier since both Factor ESG and the market are driven by the same factors and will often have positively correlated returns.

What about performance? We recently looked at investment performance of ESG, highlighting recent ESG performance and the differences between Raw ESG, Factor ESG, and Residual ESG. What we found is that, in general, increasing exposure to Residual ESG or, to a lesser extent, Raw ESG, rarely underperforms the market, and often outperforms the market, especially over the last few years. The only times when Residual ESG has notably underperformed are in the US prior to 2016 and in Japan in 2015. This indicates that Residual ESG may be the more attractive component of ESG. However, it is worth noting that in our tested portfolios the performance of Residual ESG was not notably different from Raw ESG. So, PMs who wish to avoid decomposing a vendor’s ESG score into Factor and Residual components seem justified.

These observations may be most helpful to PMs who are reluctantly under pressure to incorporate ESG into their portfolios. Addition of ESG may not always boost performance, but it also appears unlikely to be a significant drag on performance. And there have been periods of time across multiple regions in which ESG has improved performance.

(1) PwC’s 2016 ESG Pulse: Investors, corporates, and ESG: bridging the gap, available at https://www.pwc.com/us/en/services/governance-insights-center/library/esg-environmental-social- governance-reporting.html.

(2) See, for example, https://www.forbes.com/sites/christopherskroupa/2017/07/21/on-the-esg-horizon- achieving-a-global-standard/#6923a5901104; http://knowledge.wharton.upenn.edu/article/how-two- federal-rulings-are-removing-the-roadblocks-from-impact-investing/; https://www.msci.com/documents/1296102/0/PRI_MSCI_Global-Guide-to-Responsible-Investment- Regulation.pdf/ac76bbbd-1e0a-416e-9e83-9416910a4a4b;

(3) ESG: The sustainability factor. C. S. Moredo, 2018. https://www.ipe.com/reports/special- reports/factor-investing/esg-the-sustainability-factor/10023927.article. 
(4) Assessing Risk Through Environmental, Social and Governance Exposures, J. Dunn, S. Fitzgibbons, and L. Pomorski, 2017. https://www.aqr.com/Insights/Research/White-Papers/Assessing-Risk-through- Environmental-Social-and-Governance-Exposures; Foundations of ESG Investing: Part 1: How ESG Affects Equity Valuation, Risk and Performance, G. Gise, L-E Lee, D. Melas, Z. Nagy, and L. Nishikawa, 2017. https://www.msci.com/www/research-paper/foundations-of-esg-investing/0795306949.

(5) RobecoSAM Smart ESG: heavy on ESG, light on Bias, R. Feldman, 2017, http://www.robecosam.com/images/Smart_ESG_Heavy_on_ESG_light_on_bias.pdf.