How ESG Investing Has Impacted the Asset Pricing in the Equity Market

Abstract

ESG investing has gained considerable traction over the past few years and, alongside smart beta, factor investing and alternative risk premia, is one of the current hot topics for the asset management industry. Nevertheless, even though large institutions such as insurance companies, pension funds and sovereign wealth funds have invested significantly in ESG strategies over recent years and we are observing a substantial and increasing interest from other investors such as wealth management or retail investors, the question of performance remains a controversial issue and a puzzle for the financial community. Indeed, academic findings have been mixed and have revealed a U-shape pricing of stocks in the equity market, meaning that both best-in-class and worst-in-class ESG stocks have been rewarded by the equity market in the past. In this research, we analyze the relationship between ESG and performance in the recent years (2010 – 2017) since ESG was more an anecdotal and explanatory investment idea before the Global Financial Crisis. For that, we consider different regions (North America, Europe, Japan, World) and different investment styles (passive management, active management and factor investing). We show that ESG investing has been rewarded since 2014, but not before. Across the three ESG pillars, the Environment factor in North America and the Governance factor in the Eurozone performed the strongest. Overall, the study reveals that ESG does not impact all stocks, but tends to impact best-in-class and worst-in-class assets. Contrary to common beliefs, we also observe that ESG had little impact on volatility and drawdown management during the 2010-2017 period. In the case of passive management, implementing an ESG strategy helps to improve the information ratio if the investor accepts to take a tracking error risk. Finally, we show that ESG investing is related to factor investing. In particular, we conclude that ESG investing remains an alpha strategy in North America, whereas it has become a beta strategy in the Eurozone.