Systematic ESG Risk and Passive ESG Investing

Abstract

Investors can regard passive environment, social, and governance (ESG) investing as a cost-effective strategy to manage systematic ESG risk. This analysis aims to explain the expected performance of passively following an ESG-screened index within the risk–return paradigm. The author formulates the ESG factor surprise by subtracting returns on ESG-screened indexes from returns on their parent indexes. This approach reveals many intriguing aspects of passive ESG investing. The empirical result of the index model for the sample period from 2011 to 2020 shows that the daily returns of ESG-screened indexes (constructed through negative screening without portfolio skews) have a beta coefficient lower than 1. The EGARCH analysis confirms that ESG factor surprise has a lower long-run level, higher persistence, and minor asymmetry compared with market factor surprise. These empirical findings show that passive ESG investing may be suitable for value-based investors. If investors want to enhance their risk-adjusted return through passive ESG investing, they may need to seek alternative indexes with more ESG exposure deviation.