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Integrating sustainability risks in asset management: the role of ESG exposures and ESG ratings

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Abstract

The rising sustainability awareness among regulators, consumers and investors results in major sustainability risks of firms. We construct three ESG risk factors (Environmental, Social and Governance) to quantify the ESG risk exposures of firms. Taking these factors into account significantly enhances the explanatory power of standard asset pricing models. We find that portfolios with pronounced ESG risk exposures exhibit substantially higher risks, but investors can compose portfolios with lower ESG risks while keeping risk-adjusted performance virtually unchanged. Moreover, investors can measure the ESG risk exposures of all firms in their portfolios using only stock returns, so that even stocks without qualitative ESG information can be easily considered in the management of ESG risks. Indeed, strategically managing ESG risks may result in potential benefits for investors.

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Notes

  1. Private investments are needed to close the €180-billion gap in additional yearly investments needed to meet the SDGs (European Commission 2018).

  2. There is an ongoing debate regarding the impact of ESG integration on financial performance. Though there is evidence for CSR affecting corporate performance [for example, Hong and Kacperczyk (2009); El Ghoul et al. (2011); Chava (2014) and Eccles et al. (2014)], literature investigating the performance of ESG portfolios shows mixed results. Papers covering the US market [for example, Derwall et al. (2005); Galema et al. (2008); Dorfleitner et al. (2018); Gloßner (2018) and Amiraslani et al. (2019)] and the European market (Brammer et al. 2006; Mollet and Ziegler 2014; Auer 2016; Auer and Schuhmacher 2016 and Barth et al. 2019b) indicate a partly positive relation between CSR and performance for the US, whereas the evidence for Europe does not show a significant performance impact.

  3. Similarly, Jin (2018) applies one aggregated ESG-related factor to evaluate U.S. equity funds and finds that fund managers tend to hedge ESG-related systematic risks.

  4. Kendall’s rank correlations are slightly lower in magnitude, but p values remain below 1%.

  5. Although we use ESG ratings in the construction of the ESG factors, ESG exposures should be largely independent of greenwashing and incomplete data due to diversification effects.

  6. E- and S-ratings for each firm are benchmarked against the firm’s industry peers. Governance scores are calculated against the firm’s country of headquarter.

  7. We thank Kenneth R. French for supplying this data for Europe at http://mba.tuck.dartmouth.edu/pages/faculty/ken.french/data_library.html. Since these European factor returns are calculated in US dollars, we converted them into Euro following Glück et al. (2019).

  8. The number of stocks in the portfolios SL, BL, SH and BH ranges between 69 in 2003 to 139 in 2016.

  9. We apply an F-test for nested models, as the 6F-FFC model is a subset of the 9F-ESG model.

  10. Detailed results, including all coefficient estimates, are available upon request.

  11. Shapely values account for the interplay between the individual factors. For a deeper discussion of methods to decompose R2, see Klein and Chow (2013).

  12. Considering that quintile returns might be heteroskedastic or non-normal, we also apply the Welch (1938) test and the nonparametric test by Kruskal and Wallis (1952). The results remain robust.

  13. Taking into account that returns on quintile portfolios could also be driven by factor exposures, we calculate alphas from the 6F-FFC model and again find no significant relationship between ESG exposures and alphas. These results are available upon request.

  14. Compare the discussion of the differences between ESG ratings and ESG exposures in “ESG exposures versus ESG ratings” section.

  15. For brevity, we report significant results only. Detailed results are available upon request.

  16. Results are available upon request.

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Acknowledgements

We are grateful for helpful comments and suggestions from Matthias Bank, Rainer Baule, David Buckle, Ulf Erlandsson, Xavier Gerard, Binam Ghimre, Bart van der Grient, Dennis Huber, Marielle de Jong, Antoine Mandel, Jason MacQueen, Sarah McCarthy, Zoltán Nagy, Martin Nerlinger, Satya Pradhuman, Cyrus Ramezani, Martin Rohleder, Stephen Satchell, Ingrid Tierens, Sebastian Utz, Abhishek Varma, Krishna Vyas, Martin Wallmeier, Marco Wilkens, Maximilian Wimmer and the participants of the SWFA Conference 2018 in Albuquerque, the Green Summit 2018 in Vaduz, the Summer Conference on Financial Implications of Sustainability and Corporate Social Responsibility 2018 in Nice, the International Ph.D. Seminar 2018 in Hagen and the Inquire Europe 2018 autumn seminar in Budapest. The paper received the Best Doctoral Student Paper in Investments Award at the 2018 SWFA Annual Meeting and the Inquire Prize for the best paper presentation on „ESG and portfolio construction“ at the 2018 Inquire Europe autumn seminar. A former version of this manuscript was entitled “Performance of socially responsible portfolios: The role of CSR exposures and CSR ratings”. All remaining errors are our own.

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  1. Chair of Finance and Banking, Friedrich-Alexander-Universität Erlangen-Nürnberg (FAU), Lange Gasse 20, 90403, Nürnberg, Germany

    Benjamin Hübel & Hendrik Scholz

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Hübel, B., Scholz, H. Integrating sustainability risks in asset management: the role of ESG exposures and ESG ratings. J Asset Manag 21, 52–69 (2020). https://doi.org/10.1057/s41260-019-00139-z

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