Integrating ESG in Portfolio Construction

Abstract

In this article, the authors recommend an approach to integrate environmental, social, and governance (ESG) issues into portfolios that is based on two premises. The first is that classification of firms as good or bad ESG companies should be performed using ESG items that are material in that industry. The second premise is that it is possible to overcome the sparse voluntary ESG data reported by firms by constructing an ESG good minus bad (GMB) factor and then finding those firms whose returns load significantly on this factor. The authors provide evidence that shows the superiority of using material, industry-specific ESG items and the merits of expanding the ESG classification using the ESG GMB loadings. Their approach is particularly suitable for quantitative investment approaches that invest in portfolios with large number of positions and many small active exposures, wherein vendor ESG data can be used in portfolio construction efficiently without the need to employ detailed ESG analyses of many individual firms. With such portfolios, it is less about the ESG classification of an individual company than about the aggregate portfolio tilt toward good ESG and away from bad ESG at the portfolio level.