ESG: Alpha or Duty?

Abstract

The article examines information content of Environment, Social, and Governance (ESG) from a factor exposure perspective. The author uses an integration approach of ESG in portfolio construction by using four broader MSCI USA ESG indices. The analyses have been done using risk-return, CAPM, Fama-French three-factor, Fama-French-Carhart four-factor, Fama-French five-factor, and Fama-French-Carhart six-factor asset pricing models since the inception of each of the four ESG indices. The author finds that most of the returns of these four indices are explained by the CAPM market factor and different asset pricing factors are significantly associated with returns of these ESG indices. The analyses show that there is no information content in the overall ESG score in constructing a portfolio; instead asset managers should incorporate relevant parameters forming part of the overall ESG score in their portfolio construction. The institutional investors should perform their duty of helping poorly ranked companies, with regard to ESG in changing their structural framework and thereby improve their overall ESG scores and then gaining through ESG momentum.