Constructing ESG Equity Index Portfolios—The Impact of Exclusions on Risk and Return

Based on a wide range of business involvement data, we construct and backtest rules-based ESG exclusion portfolios and assess the implications of individual exclusions as well as groups thereof on portfolio return, risk as well as factor exposures relative to the broad market. Across our sample covering companies from five equity markets (USA, Developed Europe, Japan, Developed Asia ex Japan as well as Emerging Markets) and 10 years ending in December 2022, we find the absolute of return and risk differences to be positively correlated with the portion of the underlying market that is excluded. For excess returns, this relationship largely disappears when moving from the absolute of to actual excess returns—indicating the absence of a uniform relationship between exclusions and return. Rather, the direction of the impact of exclusions on portfolio returns is found to be highly exclusion- as well as region dependent. An analysis of the drivers of return differences shows that the relevance and direction of style factor exposures is similarly exclusion- and region dependent. Once controlling for factors, we find alphas to be largely statistically insignificant. As a result of our findings, investors should pay special attention to the selection and specification of exclusions and whether these go hand in hand with systematic style factor tilts.