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Case study: ESG’s Boost to Performance

Methodology

The portfolio of stocks used in this analysis are the stocks for which we can gather this data, starting with all the stocks for which Arabesque produced an ESG score as of the 3rd of May 2021. A small proportion of these were then excluded if prices were not available for either the start date or one year later, the 3rd of May 2022. These missing prices could have been because of identifier changes or M&A activity. This left a portfolio of over 5,000 stocks on which this analysis was carried out.

The annual return is compared with the stock’s ESG score from the start of the return period. The ESG score from the start of the period is used to prevent any backwards-looking bias which could occur with the current ESG score. This ESG scoring mechanism for this data goes from 0 to 100, with 100 being the highest ESG score. We have grouped the stocks by their ESG score into these groups, under 30, 30 to 40, 40 to 50, 50 to 60, 60 to 70 and over 70 and in the chart below show the average return of stocks in these groups as well as the quartile for each bucket.

The chart clearly shows those stocks with scores in the higher ESG buckets have a higher annual return on average than those with lower scores, and this same trend is also shown in bottom and top performers through the quartiles. The only decrease in performance is in those stocks with an ESG rating over 70, which will be impacted by the small sample size number of stocks, less than 1% which have an ESG score of over 70.

Charts 1, 2, 3 & 4- ESG and Performance Case Study

Pillar Performance

Is it meaningful to compare a company focused on lowering emissions with a company focused on employment quality? ESG is a broad topic. Having shown that ESG score impacts returns, it is natural to ask which of these ESG factors: Environmental, Social or Governance is the more significant in driving returns? Below we perform the same analysis with the Environmental, Social and Governance pillar scores.

Environmental score includes Emissions, Environmental Stewardship, Resource Use, Environmental Solutions, Waste, Water, Environmental management

Social score includes Diversity, Training & Development, Community Relations, Product Access, Product Quality & Safety, Occupation Health and Safety, Human Rights, Labour Rights, Compensation, Employment Quality

Governance score includes Business Ethics, Corporate Governance, Transparency, Forensic Accounting, Capital Structure

These charts show that the governance score has a weaker link to the return. Although the correlation between return and governance score is still positive, it is low. A much stronger correlation is found in both the Environmental and Social scores indicating they are the more significant drivers of return.

It is also worth noting that the average return of all the stocks in this universe is down approximately 3% in this period, and major stock market indices are down approximately 5% over the same period. While the absolute returns are not especially impressive even on the higher ESG stocks, the relative return of higher ESG stocks over the performance of the market is strong.

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Further areas of study

An analysis of this nature is never finished, below are some questions which would lead to a deeper practical insight for fund managers.

  • Which of the more specific ESG data points behind the scores drive the improved return?
  • Would investing only in high-scoring ESG stocks decrease diversification and increase volatility?
  • What is the impact over a longer or a different time period and what is the impact of an increasing or decreasing ESG score?
  • Do these results differ by region or industry?

Conclusion

Here we have shown that stocks with better ESG scores have outperformed stocks with worse ESG scores, with the environmental and social factors having the most significant impact on returns. While this analysis is not exhaustive, and a more in-depth study can be carried out, active managers should realize that while ESG will certainly continue to grow in prominence in investors’ minds, it can be an important factor in and of itself in generating performance.

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