On responsible investment: Generating abnormal returns with screening strategies

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.