Toward ESG Alpha: Analyzing
ESG Exposures through a Factor
Lens
Thomas Fura
WHAT IS
ESG?
What is Alpha?
Simply put Alpha is a comparison of how
an equity compares to general market
and whether it under or over performs in
comparison.
Focus of the Article
How do Mutual Funds and Stock Indexes
that take ESG into account for investment
choices compare to those who do not
and the general market?
How The Links between ESG and Alpha/Return are measured
• Researchers decided to base data of portfolios that exclusively hold
long positions
• Custom built equations are used with metrics such as Alpha, ESG
score, beta, and portfolio weights in order to attempt to create a link
between the two
• Tables comparing various ESG focused Funds and Indexes are
Compared with the help of the equations shown
Overview of Equations Used
• Over 14 Equations were used in order to explain the mathematical
relationship between ESG and Return
• These Vary from factor risk elements to the returns of various ESG managers
portfolios
• One of the major focuses was separating the risk associated with the
industry and the Risk associated with meeting ESG standards.
• All factors of equations are based on various Morningstar ratings
Factors used to Establish the Relationship
Individual Factor Model of Returns(Example)
Start of Equation
Middle of Equation
• A is the alpha with i being the
individual securities and t being
the time held
• K is the factors of return at a
certain time
•
is the expose of security i to
the above factors of return
βikt
End of Equation
•
is the securities return shock
based on factors specific to its
asset class
εi t,
Portfolio Return Equation
Similar formula but adjusted for an overall portfolio
with the addition of the covariance
What it Really Ends Up Coming Down to…
Findings
What can be Drawn
•Overall ESG scores do not heavily effect the
performance when it comes to the each
rated fund shown
•When it comes to the active return, the high
decile ESG scores (8-10) tend to outperform
those with lower ESG ratings
Findings (Cont.)
What can be Drawn
• Funds with the highest ESG scores tend to be much
more exposed to various market factors
• Price changes seem to happen much more rapidly
with high ESG scores as shown by the increase in
momentum as the score increases
• Factors of small cap markets are taken much less into
account with high ESG score portfolios and funds
Conclusions Drawn by Researchers
• By taking on factor exposures or focusing on idiosyncratic ESG
elements that are unconnected to style factors, fund managers can
aim towards ESG levels.
• ESG outcomes are related to style criteria such as value, momentum,
quality, minimum volatility, and size.
• When investors select funds with high ESG scores, those funds tend
to also have significant factor exposures.
Conclusions Drawn by Myself
• Funds that focus on having a high ESG tend to be much more risky in
general
• My reasoning for this is that these funds have companies that are much more
sensitive to government regulations
• With the added risk although returns can be higher especially with
the risk focused on each stock
• For example, if a company does very well on carbon rating they have much of
their taxes paid for because of carbon credits, this can lead to greater growth
and earnings for the company
• The profits by the ESG focused funds and companies can be severely
limited by holding themselves to such a standard