ESG-screening and factor-risk-adjusted performance: the concentration level of screening does matter

ABSTRACT

Constructing ESG-screened portfolios aims to reduce the aggregate ESG-risk at the portfolio level by excluding low ESG-score constituents from the selection universe. But ESG-screening imposes limits on potential diversification as well as alters risk exposures to systematic factors. To investigate ESG-screening’s impact on the factor-risk-adjusted performance of portfolios, we construct ESG-screened portfolios consisting of US equity mutual funds according to their returns-based ESG-scores. The result of performance contribution analysis for the sample period from 1999 to 2018 suggests that investors need to treat the concentration level of ESG-screening as a search parameter to balance the costs and benefits of ESG-screening.

KEYWORDS:

• ESG
• ESG screening
• ESG-related exclusions
• best-in-class
• concentration level of screening
• factor-risk-adjusted performance
• specific risk
• systematic risk
• performance contribution
• responsible investing
• downside protection

JEL:

• C15
• G11
• G12
• G13
• G22
• G33

Acknowledgments

We thank the editorial team of the Journal of Sustainable Finance & Investment and reviewers for helpful comments and suggestions.

Disclosure statement

No potential conflict of interest was reported by the author(s).

Disclaimer

The views expressed in this paper are those of the authors and do not necessarily represent the views of the National Assembly Budget Office in Korea.

Notes

1 We can also extend our coverage in cross-sectional data through returns-based ESG-scores for funds whose holdings-based ESG-scores are not available. With 1262 funds active at December 2018 (out of a total sample of 2354 total sample funds), the Morningstar database contains ESG scores for 1233 funds.

2 A returns-based ESG-score of zero would indicate neutral to systematic ESG-risk, a positive score represents hedging systematic ESG-risk, and a negative score implies maintaining high exposure to systematic ESG-risk.

3 For a robustness check, we consider an alternative portfolio construction methodology: value-weighting. and return calculation. In such a case, the portfolio Pk consists of high ESG-score funds making up the k percent of total values (sum of fund sizes) of the eligible universe. We found that most results presented henceforth were not sensitive to changes in portfolio formation, although the outcome of using value-weighted portfolio returns is not reported here for brevity.

4 Morningstar classifies funds as being large-cap, mid-cap, or small-cap based on the market capitalization of the fund’s stock holdings and as value, blend, or growth based on the value-growth orientation of the stock holdings (Morningstar 2018).