How Company Size Bias in ESG Scores Impacts the Small Cap Investor

Abstract

The rising popularity of socially responsible investing (SRI) has increased interest in the relationship between traditional measures of corporate financial performance (CFP) and the emerging field of corporate social performance (CSP). SRI investors have tended to have a large capitalization (cap) stock focus that has served them well in the past, but that may be suboptimal in the future if we return to a period of small cap outperformance. Using environmental, social, and governance (ESG) scores as a proxy for CSP, our research supports past studies showing a large cap bias in measures of CSP. Narrowing our focus, we find that within the US small cap stock universe, the correlation between firm size and ESG scores is greatly reduced. We construct small cap ESG leaders and laggards portfolios and test their performance. We demonstrate that performance was not affected by neutralizing these portfolios with respect to firm size. Our results reinforce the idea that CSP proxies such as ESG scores have the potential to practically enhance portfolio performance in US small cap stocks. <b>TOPICS:</b>ESG investing, analysis of individual factors/risk premia, portfolio construction, performance measurement <b>Key Findings</b> ▪ ESG size bias is not as significant in US small cap stocks as it is in US large cap stocks. ▪ Stocks with high (low) ESG scores outperform (underperform) the market in the US small cap space. ▪ It is possible for US small cap portfolio managers to use ESG as an alpha generating tool without taking size risk.