The Impact of ESG Scores on Portfolio Return and Risk: An Empirical Study

Abstract

This thesis aims to contribute to the debate on whether Environmental, Social, and Governance (ESG) ratings have an impact on financial performance. The study is based on ESG ratings from Refinitiv and covers the STOXX Europe 600 Index over the sample period 2011 to 2020. The main objective is to investigate whether high portfolios, consisting of ESG leaders, perform significantly different than low portfolios, consisting of ESG laggards. For this purpose, decile portfolios are formed on the basis of companies’ relative ESG ratings, which defines the positive screening approach. In order to study the portfolios’ comparative performance, several risk and return measures are computed. Furthermore, the returns are tested using popular performance benchmark models, including CAPM, Fama-French 3-, and 5-Factor models. The findings provide supporting evidence for an outperformance in the high portfolio, according to the ESGC score. In contrary, the remaining scores, ESG, E, S, and G, provide evidence for an outperformance in the low portfolio. However, the results also indicate that the low portfolios generally exhibit higher levels of downside risk. In order to test the robustness of the results the sample period is split into two sub samples. Here, a general positive development is observed. The early sub sample provides clear evidence of an outperformance in the low portfolios, whereas the late sub sample shows outperformance in the high portfolios according to both the ESGC, E, and S scores. Lastly, it is tested whether the results are subject to industry bias. This is done by constructing decile portfolios based on the “best-in-class” screening approach, where companies are assigned according to their relative ESG performance among their industry peers. The analysis shows similar findings, indicating that the results are not only a product of sector displacement. Overall, the study cannot provide a clear-cut conclusion towards the direction of the relationship between ESG scores and financial performance. However, the findings do show that investors have been able to generate abnormal returns by incorporating ESG ratings into their investment decision-making over the course of the analysis period. Thus, the paper concludes that ESG scores do have an impact on financial performance.