Financial Quality Metrics and ESG Factor Interactions in Equity Markets

Abstract

As investor interest in indexes’ tilt toward quality factors grows many of them mistakenly conflate ESG (environmental, social, and governance) factors with quality factors when they seek to integrate ESG data into their investment process. This article offers a different perspective on the relationship between quality factors and ESG factors, as well as the financial materiality of different multifactor combinations of quality and ESG factors across six-year monthly rebalanced in-sample backtests (June 28, 2013 to April 30, 2019) on the Russell 1000 Index, Russell 2000 Index, and MSCI EAFE Index. The authors compare the return streams and correlations of ROE, ROA, ROIC, and MSCI IVA Score, and their corresponding equal-weighted multifactor combinations. The ESG and financial quality factors are uncorrelated, suggesting that well-rated ESG companies are not always high-quality companies. In some cases, the combination of quality and ESG is a stronger predictor for high returns than either the quality factor or the ESG factor alone. <b>TOPICS:</b>ESG investing, mutual fund performance, factor-based models, performance measurement <b>Key Findings</b> • The article examines the relationship between quality factors and ESG factors, as well as the corresponding multifactor combinations across six-year monthly rebalanced in-sample backtests on the Russell 1000 Index, Russell 2000 Index, and MSCI EAFE Index. • The data indicates that ESG and financial quality factors are uncorrelated, suggesting that higher-rated ESG companies are not always higher-quality companies. • For both domestic and international large-cap equities, the combination of quality and ESG is a stronger predictor for higher returns than either the quality factor or the ESG factor alone.