Handbook of the Economics of Finance

The Price of Sin: The Effects of Social Norms on Markets

Many studies have focused on the relationship between companies with strong environmental, social, and governance (ESG) characteristics and corporate financial performance. However, these have often struggled to show that positive correlations—when produced—can in fact explain the behavior. The authors of this article provide a link between ESG information and the valuation and performance of companies, by examining three transmission channels within a standard discounted cash flow model—which they call the cash-flow channel, the idiosyncratic risk channel, and the valuation channel. They tested each of these transmission channels using Morgan Stanley Capital International ESG Ratings data and financial variables. This showed that companies’ ESG information was transmitted to their valuation and performance, both through their systematic risk profile (lower costs of capital and higher valuations) and their idiosyncratic risk profile (higher profitability and lower exposures to tail risk). The research suggests that changes in a company’s ESG characteristics may be a useful financial indicator. ESG ratings may also be suitable for integration into policy benchmarks and financial analyses. TOPICS: ESG investing, security analysis and valuation, risk management

/pdf/foundations-of-esg-investing-how-esg-affects-equity-3x6jc33syj.pdf

Foundations of ESG Investing: How ESG Affects Equity Valuation, Risk, and Performance

We analyze the ESG rating criteria used by prominent agencies and show that there is a lack of a commonality in the definition of ESG (i) characteristics, (ii) attributes and (iii) standards in defining E, S and G components. We provide evidence that heterogeneity in rating criteria can lead agencies to have opposite opinions on the same evaluated companies and that agreement across those providers is substantially low. Those alternative definitions of ESG also affect sustainable investments leading to the identification of different investment universes and consequently to the creation of different benchmarks. This implies that in the asset management industry it is extremely diffcult to measure the ability of a fund manager if financial performances are strongly conditioned by the chosen ESG benchmark. Finally, we find that the disagreement in the scores provided by the rating agencies disperses the effect of preferences of ESG investors on asset prices, to the point that even when there is agreement, it has no impact on financial performances.

https://onlinelibrary.wiley.com/doi/pdf/10.1002/csr.2177

Inside the ESG ratings: (Dis)agreement and performance

The role of bitcoin in well diversified portfolios: A comparative global study

In the past 10 years, ESG considerations have increasingly become integrated into mainstream portfolio management. A large number of long-term institutions such as pension funds, sovereign wealth funds, insurance companies, endowments and foundations have signed up to the UN Principles for Responsible Investment. Many of these institutions either make allocations to segregated ESG mandates or incorporate ESG criteria across their entire portfolio. Asset managers have responded to this increasing demand from asset owners and have started to integrate ESG into their strategies using mechanisms ranging from exclusions based on screening to full integration into the security selection and portfolio construction process.

Factor Investing and ESG Integration

This paper is the second in a three-paper series focusing on factor investing. In the first paper, “Foundations of Factor Investing”, we discussed six factors — Value, Low Size, Low Volatility, High Yield, Quality and Momentum — that historically have earned a premium over long periods, represent exposure to systematic sources of risk, and have strong theoretical foundations. We also discussed how they could be captured through indexation. In this paper, we turn to the question of how institutional investors interested in factor investing may allocate to and across factors. In particular, we introduce a new framework for how institutional investors might consider implementing factor allocations through a passive mandate replicating a single multi-factor index. We call this type of allocation a multi-factor index allocation. Multi-factor indexes combine select factor indexes into single mixes created and controlled by the investor. Multi-factor indexes historically have demonstrated four key benefits: diversification, transparency, cost-efficiency via reduced turnover, and flexibility.

https://papers.ssrn.com/sol3/Delivery.cfm/SSRN_ID2543985_code569387.pdf?abstractid=2543985&mirid=1&type=2

Deploying Multi-Factor Index Allocations in Institutional Portfolios

There has been a wide range of research in academia and the asset management industry about the financial benefits of ESG investing. However, the question of how to achieve consistency when integrating ESG has not obtained the same level of attention. As a result, ESG integration currently is often applied inconsistently and incompletely across asset owners’ portfolios. The authors of this article focus on how asset owners can implement ESG integration through index-based allocations to portfolios that seek to replicate ESG indexes. Index-based approaches offer consistency, transparency, and replicability and are generally cost-effective. Over a seven-year study period, global and regional versions of the MSCI ESG Leaders Indexes (as proxies for regional allocations) resulted in significant variations in their respective ESG profiles and performance, but in all instances, there was a clear reduction in all key risk measures.

Performance and Risk Analysis of Index-Based ESG Portfolios

Typical multi-asset-class portfolios can be dominated by equity risk, even when the allocation to equities is relatively modest. Achieving risk parity between equities and fixed income in an unlevered portfolio would require significant rebalancing towards fixed income. While such rebalancing can lead to a reduction in risk, portfolios with high fixed-income allocations have historically underperformed equity-dominated portfolios. However, achieving risk parity through leverage, while keeping the initial asset allocation constant, would typically require substantial levels of leverage and could lead to a significant increase in portfolio volatility. The authors combine rebalancing and leverage to construct risk parity portfolios that target the same expected return and the same portfolio risk as the initial asset allocation and examine the performance of these portfolios in different market conditions.

Constructing Risk Parity Portfolios: Rebalance, Leverage, or Both?

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