Do ESG scores contribute to financial return?
Do ESG scores contribute to financial return?
Adam Gustafsson, Research Analyst – Global Equities, and Katerina Papamihail, SI Quants, argue that while they are one of many inputs into our investment process, our research suggests they do add to financial returns.
- We tested ESG scores’ incremental contribution to financial performance of hypothetical high and low intrinsic value portfolios over time
- Results from a backtest give us confidence that considering ESG scores in company analysis contributes to incremental financial returns
Sustainable investing and the integration of ESG scores have come a long way in the last few years. Back in 2017 we published a paper called Measure what matters. In it, Adam Jokich, Portfolio Manager, argued that leveraging environmental, social and governance data was a natural evolution of fundamental investing and that there was positive relationship between ESG and financial investment returns (alpha). We still believe this to be true and that the relationship remains intact.
At the time of writing, the use of ESG scores is receiving some criticism and pushback. We stand firm in our philosophy and commitments, but our approach is ever evolving. ESG scores are, put simply, a datapoint, but our research reinforces the belief that sustainable investing adds value.
The Global Equity Valuations System (GEVS) has been the backbone of the Global Equities team's active investment process for over 30 years. Being able to independently estimate intrinsic value and actively invest in undervalued companies is essential to our long-term investment success. Successfully estimating intrinsic value allows investors to take advantage of market mis-pricings as they seek to generate excess returns for clients. We are convinced integrating ESG factors into an investment process can deliver incremental alpha. However, it is important to regularly test this thesis within our framework, in the context of how we use ESG scores in investment decisions.
As Alex Edmans, author of Grow the Pie and Professor of Finance at London Business School, recently wrote “Considering long-term factors when valuing a company isn’t ESG investing; it’s investing. Indeed, there’s not really such a thing as ESG investing, only ESG analysis.” We agree, and that is why our investment approach has long focused on combining quantitative data with forward-looking fundamental and sustainability research and engagement. While ESG scores do not capture the full complexity of sustainability related factors as a driver of long-term company performance, we believe considering ESG scores in conjunction with our GEVS intrinsic value estimates should add incremental alpha. That is why we decided to revisit the thesis and analysis laid out in the original Measure what matters paper.
Does ESG add alpha? Let’s test it.
Does ESG add alpha? Let’s test it.
We start with the MSCI All Country World Index (ACWI) constituents.1 With 2,532 companies on average during the last 10 years, the index covers approximately 85% of the global investable equity opportunity set across both developed and emerging markets. Within this universe, stocks covered by analysts in our GEVS are selected narrowing down the universe to 1,295 stocks.2 Analysts use GEVS to estimate present value of a company’s future free cash flow and compare it to the firm’s current market price to calculate a predicted potential alpha. We have recorded analysts’ GEVS estimates, based on a multi-period discounted cash flow, for decades in our system which facilitates comparisons over time.
Figure 1: Backtest Company Universe
Illustrates the 1,295 corporate constituents of the UBS AM Global Equity Valuations System as a subset of the 2532 constituents of the MSCI All Country World Index
Since mid-2020, we have generated the UBS ESG Consensus Score through our proprietary ESG Risk Dashboard, which quantifies the most financially important environmental-, social- and governance-related risks and opportunities for companies. To allow us to consider a longer time horizon, prior to mid-2020, we have adopted the MSCI ESG rating3 to backfill prior periods. MSCI assesses thousands of data points across 35 ESG key issues, focusing on the intersection between a company’s core business and the industry issues that can create significant risks and/or opportunities for a company. This gives us close to complete ESG score coverage for the GEVS-covered universe.
Our investment decisions are complex and account for multiple considerations and constraints. Still, our backtest highlights two of the essential components for typically identifying a security for sustainability-focused strategies: high intrinsic value and high ESG scores.
Figure 2: High Intrinsic Value and High ESG Scores
Illustrates the four portfolios in the back test, including low intrinsic value/low ESG, low intrinsic value/high ESG, high intrinsic value/low ESG and highlights high intrinsic value/high ESG
To evaluate the historical contribution of ESG scores within our investment process, we created four equally sized, sector neutral, long-only portfolios with stocks selected on the intersection of two criteria: Intrinsic value; and ESG score. First, the universe is split 50/50 based on high/low intrinsic value. Then, each of these two groups is split 50/50 based on high/low ESG scores. This results in four equally sized portfolios with around 300 stocks in each. We ran the hypothetical backtest for the 10-year period 2013-2023 with annual rebalancing using monthly datapoints recorded point in time.
Figure 3: Portfolio construction
Illustrates the four portfolios construction methodology
Our results show that the portfolio with high analyst estimated intrinsic values outperforms the one with low. Interestingly, ESG scores adds incremental returns to both the high and low intrinsic value portfolio. The portfolio that performs the best is the one with both high intrinsic values and high ESG scores.
Across all active equity strategies, we invest in the stocks our analysts estimate have high intrinsic value. Therefore, the most important question for us is does the integration of ESG add value?
Indeed, in the backtest of these hypothetical portfolios, we do find this to be the case, with the top ESG portfolio outperforming the bottom by 30% over the 10-year period, translating to a 1.6% annualised additional return (see Figure 4 and Table 1). While these results are theoretical, they give us confidence that considering ESG scores contributes to incremental financial returns.
Figure 4: Portfolio performance and excess return
Top vs. Bottom
Top ESG 50%
Bottom ESG 50%
Shows the annualized returns, hit ratio, volatility, Sharpe ratio and Sortino ratio for the portfolios
What remains unexplained by traditional factors
It has become a stylized fact within the investment industry that stocks with high ESG scores tend to score higher on quality, be less volatile, and larger in size. While we see no meaningful contribution to size, our result indicates that exposure to quality and volatility explained part of the ESG-related performance. Also, momentum stands out with high positive contribution within our backtest.
Breaking down the 1.6% annualized excess returns of the top ESG portfolio with respect to the bottom, we find that 2.7% is attributed to local and -1.0% to currency element. Drilling further into the 2.7% local excess, 1.8% is attributed to common factors (risk, industry, country) while 0.9% is strategy specific – and thus while not definite, could be attributed to ESG (see Table 2)
This would further reinforce the conclusion that ESG integration enhances stock selection, after taking into account other influences, such as traditional and regional factors. Our investment process has always stressed that ESG cannot and should not be thought of as separate from traditional factors, but rather they are intertwined and stock selection should therefore focus on a holistic understanding of both dimensions.
Shows the breakdown of the contributors to the excess return for the high intrinsic value/high ESG score portfolio vs. the high intrinsic value/low ESG score portfolio
Sustainability efforts go well beyond ESG integration. While our focus has shifted to a more holistic concept of sustainability, ESG scores remain a fundamental step of our investment process. Still, we believe it is important for us to continually test how ESG scores interact with our analysts’ estimates for intrinsic value, and how the combination of the two can drive financial performance.
On top of high intrinsic values, the inclusion of ESG in the backtest of four hypothetical portfolios built in line with our investment process added an additional 1.6% annualized return. Almost 0.9% of this performance remains unexplained by traditional factors, and we believe may be attributed to the inclusion of companies with higher ESG scores. While this is, of course, an indicative test of a purely hypothetical portfolios, it suggests to us that including ESG scores in the core analytics of an investment process just makes sense.
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