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Toward ESG Alpha: Analyzing ESG Exposures through a Factor Lens
Financial Analysts Journal
Authored by: Ananth Madhavan, Aleksander Sobczyk, Andrew Ang
Summary notes by Hillsdale:
“Even in the absence of long time series for certain ESG data, a reasonable assumption is that if factors correlate highly with ESG attributes today, they did so in the past.”
They used Morningstar mutual fund data (for 1300 actively managed funds) and MSCI ESG scores for 5 years ending in 2019, together with factor loadings from MSCI factor indexes (value, momentum, quality, low vol, large cap, small cap). They found that funds with higher ESG scores had higher momentum and quality exposures. Funds with higher environmental scores had higher momentum exposures in particular. Their Fama-French decomposition showed funds with higher ESG scores had lower market beta, lower vol, larger size and negative exposure to value. I would say nothing from these results is unexpected.
The authors do note several caveats with their analysis: they used only one source for ESG scores (MSCI) and their analysis was done over a short period (5 years). I would add a few more, most notably they didn't consider sector exposures.
Their most important conclusion comes from when they compared fund active returns vs ESG scores and found that ESG metrics themselves don't provide excess returns but may appear to do so from the momentum, quality etc. factors that come along with them.
“...the link between high ESG ratings and high returns is only through the ESG components that are correlated with factor components. Other ESG components unrelated to factors carry insignificant excess return premiums that are economically small.”
This is the lesson for us to heed from this article: when we look at new factors (and not just ESG-based ones), how much of their excess returns do we get from elsewhere already?