Constructing and Deconstructing ESG Performance

Do good firm environmental, social and governance (ESG) ratings signal attractive stock returns? If so, what is the best way to exploit the signals? In their February 2023 paper entitled “Quantifying the Returns of ESG Investing: An Empirical Analysis with Six ESG Metrics”, Florian Berg, Andrew Lo, Roberto Rigobon, Manish Singh and Ruixun Zhang test performance of long-short ESG portfolios of U.S., European and Japanese stocks based on proprietary ESG scores from six major rating sources. They consider ESG scores from individual sources and apply several statistical and voting-based methods to aggregate ESG ratings across sources, including: simple average, Mahalanobis distance, principal component analysis, average voting and singular transferable voting. They consider equal-weighted and ESG score-weighted portfolios. They consider different percentile thresholds for long and short holdings. They assess ESG portfolio alpha with respect to widely used 1-factor (market), 3-factor (plus size and value) and 5-factor (plus investment and profitability) models of stock returns. They further test long-short portfolios from aggregations of E, S and G scores separately across sources. Using proprietary ESG ratings, monthly returns of associated stocks and monthly factor model returns during 2014 through 2020, they find that:

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