Sustainable Investing: A Disciplined Approach
Indrani De, CFA
The presentation is based on the published empirical paper:
Are All Components of ESG Scores Equally Important?
Indrani De, CFA & Michelle Clayman, CFA
Published in NYSSA ‘The Finance Professionals’ Post’, July 2010
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Evolution of Sustainable Investing
- From ‘Exclusionary’ viewpoint to a ‘Best in Class’ viewpoint.
- From something dedicated to few investors to a mainstream product.
Empirical research on responsible investing has concentrated on:
(a) Does responsible investing improve or detract from investment performance?
(b) A lot of the research has focused on one component of responsible investing typically corporate governance issues, environmental-friendliness
Our research builds upon existing literature by asking:
Are all aspects of responsible investing equally important for stock analysis?
Can you/ how to combine these different aspects of Sustainable Investing
in a systematic quantitative way to make better equity investment decisions?
Factors in Sustainable Investing
Presence in ‘Sin’ areas – Gambling, alcohol, military….
E = Environment
S= Social
G = (Corporate) Governance
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Methodology
Database
KLD Stats (KLD has since been taken over by MSCI)
Annual database – data as of 12/31/YYYY, data released as of mid February year
YYYY+1. Avoid look-ahead bias by measuring the dependent variables starting
February YYYY+1 onwards.
Sample years – 1995 through 2006 (first data as of 12/31/1995, till 12/31/2006)
Sample size - initial years, @ 650 (S&P 500 or Domini 400), From 2001, @ 1100
(S&P 500 or Domini 400 or Russell 1000), From 2003, @ 3000 (S&P 500 or Domini
400 or Russell 1000 or most of Russell 2000)
List out strengths & weaknesses in different areas.
Broad areas–Environment, Social practices, Corporate Governance, Presence in ‘Sin’
Sub-areas within each Broad area: Social issues - diversity, giving to community,
concern for employees.
1 or 0 in each sub-area strength or weakness.
For Sin, lists out the different ‘sin’ areas it has presence in.
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Component sub score = Quantify a company’s performance in each area
(Environment sub score, Social sub score, Governance sub score)
Social sub score = (# of Strengths in Social)–(# of Weaknesses in Social)
Sin Sub Score = 0 – (# of Sin area presence)
Each sub score is measured positively, meaning higher score is better.
Overall ESG Score = ∑ (Component sub scores n);
where n = Environment, Social, Governance, Sin
EW scoring – equal weight to every strength (weakness).
Equal weight to each sub area of responsible investing.
Equal weighting process precludes any subjective bias of assuming one area to
be more or less important.
Independent variables - the component sub-scores and the Overall score.
Use the Scores in different ways:
(a)as a continuous measure
(b)as a discrete measure –
(b i) binary classification of Good (G) or Bad (B), G = Score of [>=0], Else B
(b ii) three-way classification of Good, Neutral or Bad. (Three definitions of G,N,B).
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Since the results of the different discrete measures are broadly similar, I will report
only the results of the binary classification (G) & (B).
Dependent variables;
- Stock Returns
- Return on Equity
- Stock returns & ROE measured over (i) One Year (ii) Three Years (iii) Five Years
- 12 one-year periods, 11 three-year rolling periods, 8 five-year rolling periods
Control variables;
- Sector effect, using the GICs sector classification.
- Size/ market Capitalization.
- Analyze the consistency of results over time so that outlier time periods are not
driving the results
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Main Results
Overall ESG scores have a predictive & positive effect on subsequent total stock
returns and ROE. The predictive ability is much stronger for ROE.
But the different sub-scores have very different information content.
The most meaningful sub scores were (a) Corporate Governance (b) Social score
The least meaningful sub score was presence in ‘sin’ areas.
Corporate Governance scores are the best predictor of stock return, with a positive
association. This effect is pronounced over the medium to long run (three to five
year)
Social scores have a greater positive effect on ROE. This effect holds true over the
short, medium & long-term investment horizon.
Our results are robust after controlling for the sector effect and size effect.
ESG factors have stronger predictive power for midcap and small cap companies.
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Overall Sample, [Binary Classification G, B]
Impact of Overall ESG score on Stock Returns
For G & B companies in each annual dataset, calculated their average Total Stock
Return and ROE (for subsequent 1, 3, 5 years). T Test for the difference in mean.
Time Period
# of Rolling Time Periods
# of Periods G had higher stock returns
One Year
12
5 = 42% of time (2=17% statistically significant)
Three Year
11
6 = 55% of time (2=18% statistically significant)
Five Year
8
5 = 63% of time (2=25% statistically significant)
Impact of Overall ESG score on ROE
Time Period
# of Rolling Time Periods
# of Periods G had higher ROE
One Year
12
11 = 92% of time (4=33% statistically significant)
Three Year
11
11 = 100% of time (3=27% statistically significant)
Five Year
8
8 = 100% of time (3=38% statistically significant)
‘Good’ ESG companies tend to have higher stock returns over 3 - 5 years.
‘Good’ ESG companies almost always have higher ROE, though the difference
may not always be statistically significant.
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Effect of Overall ESG, Controlling for Sector Effect
Classified the G & B companies in each annual dataset by their GIC sectori.
Calculated their dependent variables (e.g.1-yr return) for each rolling time period t
(e.g.12 one-year period t).
• Mean(Gi,t), Mean(Bi,t).
• Get the average over all [t] for (G) & (B) in each sector i = Mean(Gi), Mean(Bi,)
• Calculate the % of sectori where (G) had higher one-year stock returns.
• Do the same for other dependent variables.
% of Sectors G is higher/ better than B
Average one - year stock returns
50%
Average three - year stock returns
50%
Average five- year stock returns
70%
Average one - year ROE
80%
Average three - year ROE
90%
Average five - year ROE
90%
Good companies have higher average long term returns, & ROE in majority of
sectors
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Effect of Overall ESG : Sector Effect & the Consistency Over Time
Same data as last slide, summarize in what % of sample years [(G) > (B) in sector i]
The top-left cell reads that in 75% of years, (G) had higher 1-year stock return
than (B) in the Discretionary .
% of Years
1Yr Return 3Yr Return 5Yr Return 1Yr ROE
3Yr ROE
5Yr ROE
Discretionary
75%
73%
63%
83%
91%
75%
Staples
58%
55%
75%
67%
73%
50%
Energy
67%
82%
88%
50%
55%
75%
Financials
33%
45%
0%
83%
100%
100%
Healthcare
58%
82%
88%
67%
82%
100%
Industrials
42%
55%
50%
92%
91%
100%
Technology
67%
82%
75%
92%
55%
63%
Materials
17%
36%
25%
75%
64%
38%
Telecom
67%
64%
25%
92%
100%
100%
Utilities
50%
45%
50%
42%
27%
50%
Results are consistent over time !!
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Main Conclusions: Impact of the Overall ESG Score
Good’ ESG companies tend to have higher stock returns over the three to five
year investment horizon.
‘Good’ ESG companies almost always have higher ROE, though the difference
may not always be statistically significant.
Good companies have higher average long term returns, and ROE in majority of
sectors (70% to 90% of GICs sectors)
These results are consistent over time !!
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Impact of the Component Sub-scores
Multivariate Regression Model:
Y = Intercept + α Environment + β Social + µ Governance + δ Sin + €
Y = [1year return, 3year return, 5year return, 1year ROE, 3year ROE, 5year ROE]
Run the regression model over rolling 1, 3 and 5 year horizons.
Analyze the size, sign, statistical significance of the coefficients α, β, µ, δ
Are the Coefficients (a) Positive and (b) Positive & Statistically Significant?
Y
# of Rolling
time period
α
(Environment)
β
(Social)
µ
(Governance)
δ
(Sin)
1 year return
12
9, 1
5, 2
5, 1
6, 1
3 year return
11
6, 2
4, 1
7, 4
5, 0
5 year return
8
6, 3
2, 1
6, 4
3, 0
1 year ROE
12
3, 0
12, 10
2, 0
2, 1
3 year ROE
11
4, 0
11, 8
2, 0
2, 2
5 year ROE
8
3, 0
8, 6
3, 0
2, 0
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Main Conclusions: Impact of the Component Sub-scores
Corporate Governance scores usually have a positive, and often statistically
significant impact on subsequent three & five year stock returns.
Social scores have a very strongly positive and almost always statistically
significant impact on ROE over short to fairly long term horizon.
Environment scores tend to have a positive effect on returns & ROE
Presence (absence) in ‘Sin’ areas have no measurable impact on returns or ROE.
Corporate Governance and Social scores are the important component subscores in the ESG analysis.
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Impact of the Overall ESG & Sub-Component Scores, Controlling for Size
We analyzed whether the predictive power of the ESG factors holds after
controlling for size effect. The three market capitalization (mc) buckets used:
(a) Greater than $ 9 billion [Large cap] - L
(b) Between $ 5 to 9 billion [Mid cap] - M
(c) Between $ 250 million to $ 5 billion [Small cap] - S.
We excluded the micro-cap companies since they tend to have outlier effects.
Overall ESG & the sub-scores. Discrete classification - G & B.
Classified the companies in each annual dataset into
(a) G & B (b) Market capitalization mc.
Calculated their dependent variables (e.g.1-yr return) for each rolling time period t
(e.g.12 one-year period t).
Mean(G mc,t), Mean(B mc,t).
Get the average over all [t] for G & B in each Market capitalization mc
Mean(G mc), Mean(B mc,)
For Overall ESG & sub-scores, tabulate [2 x 2 table] of [MC, Dependent Variable]
to see if G or B did better.
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Overall ESG Scores
1 Year Return
3 Year Return
5 Year Return
Large Cap
G
G
B
Mid Cap
G
G
G
Small Cap
G
G
G
Governance Sub-scores
1 Year Return
3 Year Return
5 Year Return
Large Cap
G
B
G
Mid Cap
G
G
G
Small Cap
B
G
G
Environment Sub-scores
1 Year Return
3 Year Return
5 Year Return
Large Cap
B
G
B
Mid Cap
G
B
B
Small Cap
G
G
G
Social Sub-Scores
1 Year Return
3 Year Return
5 Year Return
Large Cap
G
G
B
Mid Cap
B
G
G
Small Cap
G
G
G
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ESG factors have greater predictive ability on stock returns in mid and small.
Overall ESG Scores
1 Year ROE
3 Year ROE
5 Year ROE
Large Cap
G
G
G
Mid Cap
G
G
G
Small Cap
G
G
G
Governance Sub-scores
1 Year ROE
3 Year ROE
5 Year ROE
Large Cap
G
G
G
Mid Cap
B
G
G
Small Cap
G
G
G
Environment Sub-scores
1 Year ROE
3 Year ROE
5 Year ROE
Large Cap
G
G
B
Mid Cap
G
G
G
Small Cap
G
G
G
Social Sub-Scores
1 Year ROE
3 Year ROE
5 Year ROE
Large Cap
G
G
G
Mid Cap
B
G
G
Small Cap
G
G
G
The predictive ability of ESG factors on ROE remains after controlling for15size.
Main Conclusions: Impact of the Overall ESG & Sub-Component Scores,
Controlling for Size Effect
• The positive association between Good ESG scores and subsequently higher
stock returns and ROE, holds after controlling for the size effect.
• For stock returns, the predictive ability of ESG factors is stronger in midcap and
small caps.
Summarize
• The ESG profile of a company is a predictor of its financial performance
and long term stock returns. Good companies, defined as those having
more strengths than weaknesses in various ESG fields perform better
financially and give better returns.
• The corporate governance and social practices of a company are
particularly important.
• These results hold after controlling for the sector and size effect.
• ESG practices of a company are important considerations from an
investment perspective.
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