ESG Investing in Public Equity Markets
There is a strong ex-post association between ESG ratings and stock return whereby higher-return companies had higher prior ESG ratings on average and the highest return stocks always had better ESG profiles, which implied that an active manager seeking the outperforming stocks could improve their probability of doing so by eliminating the lowest-tail ESG stocks. Eliminating the lowest-tail ESG companies tended to reduce portfolio volatility. The results were similar using returns or risk-adjusted returns. ESG ratings were not significantly predictive of stock return except during the peak financial crisis period. However, there was a significantly strong negative correlation between better ESG ratings and stock volatility, and this relationship, implying portfolio diversification opportunities through reduction of the average stock-specific risk, was stronger when market volatility was higher. The positive correlation between ESG rating and risk-adjusted return strengthened by excluding the lowest ESG stocks. Given the well-known low-volatility anomaly (outperformance by low-volatility stocks), the research detangled the ESG and volatility effects and showed that high ESG stocks tended to be in the low-volatility group and low ESG stocks tended to be in the high-volatility group in a statistically significant way, but the ESG effect was independent of the low-volatility effect, and a positive contributor in its own right.
Given that low ESG ratings were a risk indicator, it followed that excluding such stocks as tail risk could have a beneficial impact on portfolio construction. The research used Probability Opportunity Distributions (restricting the investible universe through deletion of the lowest ESG companies and creating portfolios randomly, once from the complete universe and then from the restricted universe and comparing the “distribution of average portfolio returns” for portfolios created from the unrestricted universe and the restricted universe). The results indicated that deleting lowest-rated ESG companies as a tail risk did not necessarily impose opportunity costs and, in fact, tended to be value additive for investors in terms of higher average and maximum portfolio return. The results were similar using risk-adjusted returns. Higher return and risk-adjusted return stocks almost always had higher average ESG rating, and stocks with the maximum return and risk-adjusted return that active managers try to identify were always from the non-lowest-tail (ESG) group. There was a strong negative correlation between ESG ratings and stock volatility, and this relationship was stronger when market volatility was higher and the need for diversification benefits is higher. This implies that asset managers can enhance their stock-picking and portfolio construction ability by using ESG information and even more so by excluding the worst ESG stocks.