In this article, we examine the research addressing the question of to what extent, if any, ESG strategies improve investment performance on a risk-adjusted basis, or if they are more effectively used for the societal impact they potentially have.
The promoters of ESG Investing often promise outperformance. Despite this, in a survey conducted in 2021 among European investment professionals (Le Sourd and Martellini, 2021), the two main reasons indicated by respondents for incorporating ESG into their investment decisions were to facilitate a positive impact on society (64%) and to reduce long-term risk (61%). About a third (34%) thought that incorporating ESG would serve to enhance portfolio performance. At the same time, more than a third of respondents (35%) said they were willing to accept a lower performance in exchange for a better ESG score.
This article answers the following question:
Does ESG investing improve risk-adjusted performance?
What are the Academic Insights?
From a theoretical perspective, achieving portfolio optimization using a constrained universe should lead to a lower risk-adjusted performance than when using a non-constrained universe (see Pedersen et al, 2021 and Martellini and Vallée, 2021). From an empirical standpoint, the review of the literature shows contrasting results.
Additionally, Bruno, Esakia and Goltz (2022) find that most of the outperformance of ESG strategies can be explained by their exposure to equity style factors that are mechanically constructed from balance sheet information. This result is robust across different multifactor models. Furthermore, the ESG strategies tested show large sector biases. Removing these biases also removes outperformance.
Finally, ESG can generate positive returns in certain conditions, using ESG momentum. The argument for the outperformance of stocks with high ESG scores is that stock markets underreact to ESG information, and so stocks from firms with a positive ESG impact may be undervalued. The ESG momentum strategy thus consists in overweighting stocks that have improved their ESG rating over recent time periods (Nagy et al., 2016; Bos, 2017; Kaiser and Schaller, 2019).
Why does it matter?
This article is a comprehensive review of the literature on theoretical and empirical evidence for ESG Investing. The author argues that ESG strategies should be valued for the unique benefits that they can provide, such as making a positive impact on the environment or society, as opposed to being promoted on the basis of disputable claims regarding their outperformance potential.
Abstract on ESG strategies
In this article, we ask whether ESG Investing improves risk-adjusted performance. We argue that ESG strategies should be valued for the unique benefits that they can provide, such as making a positive impact on the environment or society, as opposed to being promoted on the basis of disputable claims regarding their outperformance potential.
Dr. Elisabetta Basilico is a seasoned investment professional with an expertise in "turning academic insights into investment strategies." Research is her life's work and by combing her scientific grounding in quantitative investment management with a pragmatic approach to business challenges, she’s helped several institutional investors achieve stable returns from their global wealth portfolios. Her expertise spans from asset allocation to active quantitative investment strategies. Holder of the Charter Financial Analyst since 2007 and a PhD from the University of St. Gallen in Switzerland, she has experience in teaching and research at various international universities and co-author of articles published in peer-reviewed journals. She and co-author Tommi Johnsen published a book on research-backed investment ideas, titled Smarte(er) Investing. How Academic Insights Propel the Savvy Investor. You can find additional information at Academic Insights on Investing.
Performance figures contained herein are hypothetical, unaudited and prepared by Alpha Architect, LLC; hypothetical results are intended for illustrative purposes only. Past performance is not indicative of future results, which may vary. There is a risk of substantial loss associated with trading stocks, commodities, futures, options and other financial instruments. Full disclosures here.