The Benefits of Socially Responsible Investing: An Active Manager’s Perspective

Abstract

There has been a lot of research on the predictive power of environmental, social, and governance (ESG) ratings, the relationship between ESG ratings and subsequent stock performance, and whether using ESG data in stock analysis and portfolio management was value-additive or valuedetracting. In this article, the authors examine the relationship between the ESG ratings of a company and its stock returns, volatility, and risk-adjusted returns in the post-2008 financial crisis era. They explore the negative relationship between ESG and volatility in greater depth, given the well-documented low-volatility anomaly (outperformance of low-volatility stocks). Both (high) ESG rating and (low) volatility positively impact stock returns, but the ESG effect is independent of the low-volatility effect, and ESG is a positive contributor in its own right. Given the controversy surrounding the effect of ESG-based investment restrictions, the authors test the effect of restricting the investible universe by deleting the lower tail of ESG companies on portfolio performance. Asset managers can thus actively use the association between corporate ESG ratings and stock return, volatility, and risk-adjusted return to enhance their stock-picking and portfolio-construction abilities.