ESG Investing: From Sin Stocks to Smart Beta

TLDR: In this paper, the impact of score-based ESG exclusion on both passive investment and smart-beta strategies was studied using the MSCI World universe, and the authors found that exclusion leads to improved scores of initially standard portfolios without deterioration of the risk-adjusted performance.

Abstract: Research on socially responsible investment in equity markets initially focused on sin stocks. Since then, the availability of data has been extended substantially and now covers environmental, social, and governance (ESG) criteria. Using ESG scores of firms belonging to the MSCI World universe, the authors measure the impact of score-based exclusion on both otherwise passive investment and smart beta strategies. They find that exclusion leads to improved scores of initially standard portfolios without deterioration of the risk-adjusted performance. Smart beta strategies exhibit a similar pattern, often in a more pronounced way. Moreover, the results demonstrate that exclusion also implies regional and sectoral tilts as well as (possibly undesirable) risk exposures of the portfolios. TOPICS:Portfolio theory, portfolio construction, ESG investing Key Findings • The authors show that environmental, social, and governance (ESG) screening can substantially improve ESG scores for both otherwise passive and smart beta portfolios without reducing risk-adjusted returns. • Starting from initially passive multicountry portfolios, ESG screening may lead to substantial regional tilts, such as overweighting Europe and underweighting the US and emerging countries or sectoral bets, for instance in favor of information technology and against financial and energy stocks. • Although the broad conclusion of improved ESG profile without affecting risk-adjusted performance also holds for smart beta portfolios, aggressive exclusion of ESG low-scoring firms may lead to some reduction in exposure to targeted factors.