ESG Equity Index Investing: Don’t Forget about Factor Exposures

Abstract

We explore the risk and return characteristics of an extensive set of investable index-linked environmental, social, and governance (ESG) equity strategies, including those with a US, European, Asia-Pacific ex. Japan, Japanese as well as global developed and emerging market investment focus from 2013–2021. A style factor–based return decomposition, as well as a Shapley–Owen risk decomposition with a focus on the factors size, value, profitability, investment, and momentum, reveal that the performance of many ESG investment strategies is largely driven by well-known traditional sources of risk. Once we control for these well-known traditional sources of risk, we find only limited evidence for the existence of an independent ESG-related factor in the form of a statistically significant alpha. However, we find variability in the exposure to, and influence of, the factors explored, within and across regions as well as over time. Among style factors, the negative exposure to size is the most common statistically significant fund-level tilt. As a result of our findings, investors should form an opinion not only as to whether they expect a specific ESG index strategy to have a (factor-adjusted) positive or negative alpha, but also whether they expect it to exhibit any persistent factor tilts and whether such tilts may help or hurt long-term absolute performance.