Full Terms & Conditions of access and use can be found at

http://www.tandfonline.com/action/journalInformation?journalCode=tsfi20

Download by: [Camille Smith] Date: 05 October 2016, At: 02:42

Journal of Sustainable Finance & Investment

ISSN: 2043-0795 (Print) 2043-0809 (Online) Journal homepage: http://www.tandfonline.com/loi/tsfi20

ESG factors and risk-adjusted performance: a new

quantitative model

N. C. Ashwin Kumar, Camille Smith, Leïla Badis, Nan Wang, Paz Ambrosy &

Rodrigo Tavares

View related articles

View Crossmark data

factors show lower volatility in their s tock perfor mances than

thei r peers in the same industry, that each industry is affected

differently by ESG factors, and that ESG companies generate

higher retu rns. The study assessed, for a period of 2 y ears, 157

companies list ed on the Dow Jones Sustainability Index and 809

that are not.

things means you are less exposed in the long run.

In recent years we saw a flurry of publications demonstrating the positive financial per-

formance of sustainable investments – those that generate social or environmental impacts

alongside financial returns. Although this is positive progress, more work is necessary on

the primary link between ESG and risk. Is there a difference in the average of the standard

deviation of stocks prices of ESG positive companies vis-à-vis non-ESG stocks? Is it poss-

ible to quantitatively demonstrate this difference, and establish that ESG firms bear less

risk compared to non-ESG stocks? And, critically, since lower risk has traditionally

meant lower financial returns, how can ESG investment really be a viable investment

strategy?

Recent studies on the financial performance of sustainable investments (Deutsche Bank

2012; Eccles, Ioannou, and Serafeim 2012; Borgers et al. 2013; Allianz Global Investors

2015; Cambridge Associates and the Global Impact Investing Network 2015; Mercer

and LGT Capital Partners 2015; Morgan Stanley 2015; Eccles, Verheyden, and Feiner

2016; Khan, Serafeim, and Yoon 2015) somehow overlook the issue of risk. They

ESG on risk, even if, as the Cambridge Associates and GIIN report claims, ‘Credible

data on risk and return can help both existing and future impact investors better identify

strategies that best suit their desired social, environmental and financial criteria’ (our

italics).

The only exceptions are Morgan Stanley ( 2015) – that finds that sustainable mutual

funds had equal or higher median returns and equal or lower median volatility for 64%

of the periods examined over the last 7 years compared to their traditional counterparts

– and Eccles, Ioannou, and Serafeim (2012) that concluded that the portfolio of companies

that have adopted a substantial number of environmental and social policies for a signifi-

cant number of years exhibits lower volatility (1.43% and 1.72% on a value-weighted and

started as a study conducted within the framework of the MBA program with support

from G&P, it gradually incorporated additional IE and G&P’s resources.

This new quantitative model is designed to establish the correlation between ESG per-

formance and volatility of stock returns. We relied upon the Dow Jones Sustainability

Index [DJSI], one of the oldest and most recognized indices in the field of ESG, to identify

157 companies that have good ESG performance. To contrast, and in order to bring

statistical significance to the results, we randomly selected a greater number of companies –

809 of them – that are not listed on the DJSI. These companies can be considered repre-

ify. Additionally, there are limited stocks with trackrecords on the DJSI.

Our ESG Population of stocks is really the top of the top when it comes to ESG prac-

tices; in other words, they are the ‘best-in-class’. The DJSI selects index companies

through an independent research firm, RobecoSAM, who conducts its Corporate Sustain-

ability Assessment. This assessment is based upon primary evidence and is rules-based.

To be included on the index, RobecoSAM invites companies across the world to be ana-

lyzed. From these invitations, companies will agree to be analyzed either from completing

a questionnaire of RobecoSAM or from publically available information. RobecoSAM

then selects the very top ESG performers compared to the company’s industry bench-

mark. As a further check, a company is only eligible for selection if its score is at least

As the materiality of the ESG factors is highly related to the industry in which the firm

operates, we grouped equity stocks into 12 industries. The industry-specific sustainability

portfolios were built by equally weighting all stocks within each index to eliminate bias

caused by any single stock with large market capitalization. Similarly, equally weighted

reference portfolios were built using randomly weighted stocks.

As long-term performance tends to be skewed by a number of factors outside of ESG

factors, thus making it difficult to prove that our hypothesis is due to only ESG factors

from long-term performance indicators, we chose short-term indicators: weekly stock

returns and volatility as they are most relevant to the study. A key distinction of our

model is that it is a market-based approach, based upon real, historical stock price

returns over a period of 2 years from 1 January 2014 to 31 December 2015 to provide stat-

istically significant data points.

In our model the different degrees of risk in the equity stocks are reflected through the

volatilities (annualized) of their stock returns. In all 12 industries studied, the group of

ESG listed companies show lower stock return volatility in comparison to the reference

companies – on average by 28.67% less (see Figure 1). This lower volatility means that

companies that perform better in ESG factors exhibit less risk than the rest of companies

serve as stronger guidance in industries for which ESG factors have greater bearing.

generate short-term rewards.

Combining the two sides of investing – risk and return – we found that the relationship

between the two may not actually reflect traditional market thinking. The lower risk

brought by better ESG practices may actually improve the risk-adjusted return of the

investments in these companies. In today’s world, just as a business can no longer excel

in isolation from a thick web of stakeholders, so too investors must think in a more com-

prehensive fashion. The original equation of higher risk – higher return has not considered

those constant internal and external interactions. Our Risk-Premium model does include

these interactions and uncovers hidden value of ESG investments.

The argument is not about lower risk–lower returns, but rather about lower risk for

As can be seen from Figure 3, the Sharpe ratio for ESG stocks in every industry, with the

exceptions of the materials, energy and banking industries, is greater than those of the

reference stocks in the respective industries – on average by 7.67%. Essentially, investors

would have been able to earn higher than average return for each unit of risk taken on their

investment if they had invested in ESG stocks. For example, an investor wanting to limit

the annual volatility of investments to 50% would have earned an annualized return of

1.05% investing in Transportation companies from the reference companies list. Alterna-

tively the investor would have earned 6.61% investing in ESG companies in the same

sector. These higher Sharpe ratios are indicative of similar results that could be achieved

by specifically investing in stocks with good ESG performance.

measure as well. ESG stocks exhibit superior Treynor ratios over their reference counter-

parts in 9 out of 12 industries. The difference, on average, of Treynor ratios for ESG com-

panies and reference Companies are 11.81% (Figure 3). The three exception industries are

two of the same from the Sharpe ratio Analysis – automobile and banking. Additionally,

the durables industry is an exception to our results.

Even in the case of the both Sharpe and Treynor ratio exceptions (Automobiles, Dur-

ables and Banking), our analysis exhibits that ESG stocks are still less volatile by 20.12%,

24.54% and 37.83%, on average. Therefore, ESG stocks tend to be less risky and more effi-

cient vehicles for investments.

investment in sustainable assets.