Is ESG a Pathway to Alpha? Examining the Risk and Return of Sustainable Investing

Abstract

This thesis examines the relationship between Environmental, Social, and Governance (ESG) factors and stock performance, within the sphere of sustainable- and responsible investing. Using various factor-based models, including the Capital Asset Pricing Model (CAPM), Fama & French´s factor models, and Carhart’s four-factor model, the performance of the different ESG focused portfolios has been compared to the market and against their non-sustainable counterparts. This study mainly considers the alpha estimates, regression coefficients, R-squared values, and the impact of the COVID19 pandemic on portfolio performance. The thesis analyzes financial data stemming from the S&P500 index, and ESG data retrieved from the rating agency Refinitiv, in the period between 2014 and 2022. The data is used to calculate yearly rebalanced and relative weighted portfolios, based on the constituent’s market capitalization and ESG rating. Based on the analyzed data, this thesis has constructed eight portfolios, differentiating the environmental, social, and governance dimensions, as well as an ESG aggregated, into a top and bottom portfolio of each. The findings reveal consistent positive alpha estimates for the “Bottom E” portfolio, “Bottom S” portfolio, as well as the “Top G” portfolio, across all models and time periods, indicating these portfolios’ ability to outperform the market. Similarly, the “Bottom ESG” portfolio consistently generates a smaller, but still significant alpha, in a time with high market returns. Interestingly, the post-COVID19 period shows a potential strengthening of the ‘ESG laggard’ effect, with higher alpha estimates observed for most of the non-sustainable portfolios. This suggests a possible impact by the pandemic on the market, as well as dynamics within assets in a time of crisis. Furthermore, the R-squared values could indicate that the applied models have limited explanatory power in describing the excess return, highlighting the complex nature of the relationship between ESG factors and stock returns. Overall, the findings support the idea that ‘ESG laggards’ and companies with poor ESG performance can generate excess returns consistently, both pre-COVID19 and post-COVID19. The results also emphasize the importance of strong governance practices in generating excess returns. These findings contribute to the academic discourse on ESG and financial performance and provide insights for investors seeking to align their investments with ESG beliefs and suggest potential shifts in market dynamics during and after the COVID19 pandemic. This thesis further calls for research to develop applicable ESG models with the ability to help capture and explain stock returns.