Enlightening the financial and individual impact of Environmental, Social and Governance criteria on portfolio strategies

Abstract

The financial performance of socially responsible investment (SRI) or environmental, social and governance (ESG) products is a topical financial issue which has been discussed in many papers. Surveys indicate either an outperformance or an underperformance and in many cases no difference at all compared to conventional investments. However most of the time these surveys are only studying one variable at a time. They study either the effect and financial performance of a rejection or selection of companies or investment funds according to a criterion which may be a high or low ESG score or the practice of low or very sustainable activities for instance. The aim of this thesis is to study individual and financial effects of various portfolio strategies composed of a combination of different levels of separately E, S and G ratings in both Europe and the USA.

Prior to the allocation into portfolios regional samples are divided into samples with high governance scores (G+) and low governance scores (G-). This choice was made since corporate governance is a key indicator for the good health of a company. Moreover it is the guarantee of the inclusion of other sustainability issues such as social and environmental challenges and consequently the E and S scores. The construction of portfolios is based on a ESG segmentation of samples in three equal parts for each individual pillar. The high portfolio is composed of the top 33% companies in E and S ratings. The medium portfolio is made of the next 33% companies in these ratings. The low portfolio is built with the last 33% companies regarding these scores. Regression outcomes (alphas) can be optimised, on the one hand, by considering additional information such as currency conversion of factors to avoid exchange rate bias for the European sample, and on the other hand by the addition of industry factors into the Fama-French multi-factor model to avoid industry bias.

Findings suggest that strategies designed with multiple ESG screens, the first screen for G then simultaneous screens with E and S, yield positive alpha even though results are not always statistically significant. Higher ESG scores seem to be more valuable and correlated to financial performance for European strategies while it is the opposite with American strategies which benefit more from lower scores. Nevertheless results vary across samples and strategies but the majority of them seem to indicate that multiple ESG screens lead to positive performance.