Assessing E, S and G in a World of Factors

Stockholm (HedgeNordic) – Nowadays, talking about adding Environment, Social and Governance (ESG) factors into an investment process is common jargon, but most often, the word ‘factor’ is used in a broader sense than in the context of a systematic investment strategy. While it is increasingly accepted that investing sustainably, and taking into account ESG, produces better risk-adjusted returns, many still argue that the data quality is insufficient, the comparability between different sources weak and historical series too short to be able to integrate ESG in systematic processes fully. And yet, in some instance, there seems to be strong evidence of correlations between elements of sustainability and investment factors.

In a recent paper published on the back of a global survey conducted in collaboration with BNY Mellon, Amir Amel-Zadeh and George Serafeim point out that comparability, timeliness and reliability are the critical qualitative characteristics that make financial information decision-useful, as identified in the most widely used accounting standards (US GAAP and IFRS). It thus unsurprising that almost half of the respondents (45%) cite the lack of comparability across firms, and the lack of quantifiable ESG information (38%), or the lack of comparability over time (35%), as the limiting factors in their firm’s ability to use ESG information in their investment decision.

However, in a study performed by MSCI already more than five years ago, a quantitative strategy taking into account the firm’s ESG Research Intangible Value Assessment scores could show a positive contribution on return. The absolute or relative ESG score of stocks might not have demonstrated tremendous performance differentials, even though it was possible to produce comparable results to those of a benchmark index through optimisation. However, a ‘momentum’ tilt, which integrated the changes of ESG scores over a year, had a positive effect not only on the subsequent ESG scores of the optimised portfolio but also on financial performance. In other words, companies who are doing more of the “right things” are likely to experience a positive stock price movement.

A couple of years later, Gerhald Halbritter and Gregor Dorfleitner calculated that, indeed, the Fama and MacBeth cross-sectional regression model revealed a significant influence of several ESG factors, but that investors were unable to exploit this relationship. It is not until late 2016 that a more in-depth analysis of ESG in the context of factor investing was performed by Dimitris Mela, Zoltàn Nagy and Padmakar Kulkarni. First, the authors tested ESG as a potential new factor by integrating it into the framework of equity factor models. By assigning numerical ESG scores to companies, they argued, these numbers were quickly transformed into exposures or z-scores. However, during the period tested (January 2007 to June 2016), only the first two deciles of ESG scores showed excess returns. Lower scores didn’t show any clear relation to performance. It seemed that the lowest ESG decile also produced favourable excess returns. Moving on further into their analysis, the authors compared their ESG factors with traditional factors, digging down to stock-level comparisons. The average level of correlation they measured was low, which indicated that ESG scores were mostly independent, and therefore constitute a new source of information. However, the statistics were stable and highly significant over time. For example, a positive correlation of 0.17 with the size factor, and a negative correlation of -0.17 with the mid-cap factor were observed, which means that larger companies tend to have higher ESG scores, and furthermore, this measurement was most robust for the “E” pillar.

Interestingly, in other studies it is not the “E” but the “G” factor that has attracted the most attention. In Mela, Nagy and Kulkarni’s paper, they measured a low negative correlation of the “G” pillar with earnings variability and residual volatility of -0.10 and -0.11 respectively, but with a high level of significance. This result would suggest that companies with a good level of governance tend to show a low level of earnings variability and residual volatility. More recently, Swedish-based systematic asset manager IPM conducted a study which analysed the returns of stocks in three different geographical regions (the USA, Europe and Global) between 1996 and 2018. The results showed that the Governance factor effectively improved the relative return per annum by as much as 0.5% for globally, just below 0.25% in Europe and almost 0.5% in the US, while the relative volatility was practically unimpacted. The maximum relative drawdown, however, was significantly improved, especially in the US where it was more than 2% lower.

While research indicates that ESG is either related to factors, or have a positive influence on returns on their own to an extent, there are still opportunities for improvement. Both the quality and availability of data is improving and should provide for more precise definitions and categorisations. Besides, elements influencing the environment, for example, could start having a stronger impact on returns, as society increasingly responds to the threats of climate change. In the same vein, the opportunities engendered by global challenges, such as population growth and lack of resources, are becoming more strongly intertwined with elements figuring in ESG scores.

At the same time, as strategies are built to support the companies that provide solutions to remedy these issues, the metrics of ESG become more strongly related with return generation than with risk avoidance. There is a strong chance, therefore, that E, S and G will soon have a new opportunity to pose as relevant factors in systematic investment processes to Källström. “We have learned a lot over the past five years, and it is only natural that we strive to improve on a continuous basis. While we keep our fundamental investment beliefs firmly anchored, we constantly seek to perfect our approach in every asset class we work with. As such, this upcoming shift in hedge fund allocation can be seen as dramatic from one perspective, but it is also an evolutionary step.”


Picture: (c) P.-Chinnapong—


About Author

Aline Reichenberg Gustafsson, CFA is Editor-in-Chief of and She has 18 years of experience in the asset management industry in Stockholm, London and Geneva, including as a long/short equity hedge fund portfolio manager, and buy-side analyst, but also as CFO and COO in several asset management firms. Aline holds an MBA from Harvard Business School and a License in Economic Sciences from the University of Geneva.

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