ESG investing - getting under the hood

Environmental, Social, and Governance (ESG) investing has gathered significant momentum over recent years. This momentum has occurred as investors aim to include material extra-financial information into their investment process with the aim of improving the return characteristics of a portfolio.

While the traditional capital asset pricing model (CAPM) framework simply measures investments through the lens of risk and return, ESG investor preference must incorporate a measure of the risk and opportunity derived from absolute and relative differences on financially material E, S, and G parameters. Still, the impetus for capital allocation must be considerate of risk and return, and so we need to effectively quantify the risk and return impacts of ESG. ESG focused equity investors also need to use their investor influence with companies to encourage and require stronger corporate ESG practices and policies, as tilting an equity portfolio is on its own, unlikely to result in `real-world’ change such as lower carbon emissions, improved equality and stronger board governance.

Amidst the often quite complex topics of its overall intention and efficacy, how ESG metrics are quantified and defined, and how they are implemented in portfolios, we will instead use this paper to focus on two key issues:

    • The impact that an identical ESG methodology has on four distinct starting equity universes — the U.S., Europe, Australia, Far East (EAFE), Canada, and international emerging markets. Similarly, we conduct a back-test of a global. All Country World Index (ACWI)-weighted ESG Index composed of the regional ESG universes, assuming rebalancing back to the ACWI weights each month.
    • The relative drivers of excess returns within those universes, broken down into their Environmental, Social and Governance pillars (the word we will use to delineate the three components of ESG).

In undertaking this analysis, we hope to show that:

    • The starting region in which ESG is applied matters from a performance standpoint, and;
    • That the effect of the different pillars differs within each starting region.

Click here to read the complete article.

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