Outperformance through Investing in ESG in Need

Abstract

To maximize their effectiveness, environmental, social, and governance (ESG) strategies should target those ESG firms that are most capital constrained. Inherently, this involves seeking ESG firms that have irrationally high costs of capital and thus high expected return. We replicate results that find returns among ESG firms that are similar to those among non-ESG firms. In addition, we find that sorting stocks based on cost of equity capital generates significant positive return for both ESG and non-ESG firms. Investing in an ESG in Need index, which contains only high-ESG companies and tilts toward firms with high cost of capital, thus generates both higher social value and better return than investing in traditional capitalization-weighted ESG indexes.