On responsible investment: Generating abnormal returns with screening strategies

Luuk te Grotenhuis

Student thesis: Master thesis

Abstract

This thesis provides evidence contradicting recent studies that claim excess risk-adjusted returns can be generated by forming portfolios on extra-financial information. Three screening strategies based on environmental, social and governance (ESG) indicators are empirically tested for their ability to achieve abnormal returns over the 2004-2011 period. Responsible investment can be subdivided according to either values-driven or profitseeking investors. They have diverging motives and are respectively served by negative or positive screening strategies. It is conjectured that employing negative, values-driven screening will result in underperformance. On the other hand, positive, profit-seeking screening strategies should display outperformance. Based on MSCI ESG STATS rating data, high- and low-rated stock portfolios are formed and consequently tested for abnormal returns with the CAPM, Fama-French three-factor, and Carhart four-factor models. The results for a negative screening strategy that excludes stocks of companies in perceived controversial business areas hint towards underperformance, with a near to significant alpha value of -2.64 percent (p-value: 0.11). In contrast to earlier research, positive screening strategies only incorporating the best-performing companies on ESG indicators also exhibit underperformance. The statistically strongest result is found for the best-in-class strategy, which maintains a balanced sector allocation in the portfolio. The alpha value of -2.85 percent (p-value 0.02) falsifies the assumption that excess risk-adjusted returns can be generated by arranging portfolios on ESG information. As a result, this thesis did not find a positive link between corporate social performance and corporate financial performance. Now responsible investment is on its way to become a mainstream method of investing, the results in this thesis question whether profit-seeking investors should invest their money according to extra-financial information. Evidenced by the underperformance of positive screening strategies, it seems that money cannot be put to both socially and financially ‘good’ use.

EducationsMSc in Finance and Strategic Management, (Graduate Programme) Final Thesis
LanguageEnglish
Publication date2012
Number of pages69