The Alpha, Beta, and Sigma of ESG: Better Beta, Additional Alpha?

Abstract

Rather than treat investments as statistical objects to be optimally combined into portfolios, investors are increasingly interested in the environmental, social, and corporate governance (ESG) dimensions of their investments. Analysts traditionally evaluated these dimensions in qualitative ways, but many data providers are attempting to score these dimensions, effectively quantifying what was qualitative. For developed market equities, on the basis of one popular data provider’s ESG assessment, we evaluate the evidence on whether portfolios of highly rated ESG stocks are materially different from their complements (non-ESG stocks) in their investment opportunity sets. It is obvious that ESG stocks differ from non-ESG stocks in their ESG dimensions, but we show that ESG stocks returns are also different. Although the total return-to-total risk of ESG stocks may be lower than that for non-ESG stocks, after factor-adjusting the returns and risks, portfolios of ESG stocks with positive alpha have return-to-risk features comparable to those of portfolios of non-ESG stocks with positive alpha. For portfolios without statistically significant alpha, the portfolios of ESG stocks have lower residual volatility than portfolios of non-ESG stocks. It should be possible, by factor-neutralizing portfolios, to build better beta with comparable alpha portfolios by using ESG factors.

TOPICS: ESG investing, equity portfolio management, portfolio management/multi-asset allocation