Sustainable Column | Sustainable Alpha: ESG Excess Return Research

On August 11th, the ESG rating agency Shangdao Ronglv released a study attempting to address one of the most capital-intensive topics in ESG investment: whether ESG ratings will generate excess returns, and how.

ESG investment involves considering a company's environmental, social, and governance factors and performance when making investment decisions. Environmental factors mainly include the impact a company has on the environment during its operations, such as pollution and energy consumption; social factors include how a company treats its employees, communities, consumers, etc., such as fair treatment, consumer protection, community involvement, etc.; governance factors mainly involve a company's management structure and operational methods, such as board structure, risk management, shareholder rights, etc.

These factors reflect a company's social responsibility and its response to global challenges such as climate change, resource scarcity, and social injustice. Shangdao Ronglv's research shows a positive correlation between the ESG performance of A-share listed companies and their stock prices.

Excellent ESG performance may potentially bring investors excess returns (doing well by doing good), a concept also known in academia as "Sustainable Alpha."

Long-term Stable Returns

This study neutralizes ESG scores, ESG score changes, and ESG management scores by market value, industry, and style, and then analyzes the stock selection effects of ESG factors for listed companies in detail. Taking the Shanghai and Shenzhen 300 Index as an example, companies ranking in the top 20% of ESG scores are selected at the end of each month to construct an ESG optimization strategy; companies ranking in the top 20% of ESG score changes are selected at the end of each month to construct an ESG progress optimization strategy; additionally, companies ranking in the top 20% of ESG management scores are selected at the end of each month to construct an ESG management optimization strategy.

The study found that from July 2016 to April 2024, the ESG optimization, ESG progress optimization, and ESG management optimization strategies achieved annualized excess returns of 5.35%, 4.96%, and 6.54% respectively compared to the Shanghai and Shenzhen 300 Index, with Sharpe ratios increasing from 0.10 to 0.38, 0.38, and 0.46.

If ESG risk event-driven strategies are included, the study found that medium to high-level ESG risk events generate cumulative abnormal excess returns for listed companies during the window period. The ESG optimization strategy mainly utilizes companies' relatively stable ESG performance, while ESG risk events provide more timely updates on companies' ESG performance. By excluding stocks that have experienced medium to high-level risk events in the past 1 month or 3 months from the ESG optimization strategy, the effectiveness of the original strategy can be enhanced.

For example, after excluding stocks that have experienced medium to high-risk events in the past 1 month from the ESG progress optimization strategy, the annualized return of the strategy increased by 1.11%. Furthermore, if stocks that have experienced medium to high-risk events in the past 3 months are further excluded, the annualized return of the strategy increased by an additional 1.25%. Similarly, after excluding stocks that have experienced medium to high-risk events in the past 1 month from the ESG management optimization strategy, the annualized return of the strategy increased by 1.54%. If stocks that have experienced medium to high-risk events in the past 3 months are further excluded, the annualized return of the strategy increased by an additional 1.23% It is worth mentioning that since ESG investment is a long-term investment, this study also extends the impact time dimension of current ESG performance on future stock price transmission mechanisms, finding that the impact of ESG performance on stock price transmission is stable over a longer time dimension. The analysis results of ESG score transmission mechanisms are consistent with expectations, that is, the better the ESG performance, the better the cash flow in the next two years, and the individual and systemic risks in the next two years are relatively lower.

Substantive Issues are More Easily Transmitted

For subjective and quantitative fund managers, when integrating ESG into the investment process, they need to know which issues are financially substantive for the specific industries they are concerned about. Systematically integrating financially substantive ESG issues into the investment framework can long-term enhance portfolio returns and reduce risks. The study states that ESG issues considered to be the most substantive have a more obvious transmission effect on stock prices.

Taking the information transmission, software, and information technology services industry as an example, the most substantive ESG issues are mainly: energy and resource consumption, employee development, governance system, and business ethics. From the perspective of comprehensive cash flow, individual risk, and systemic risk transmission paths, the transmission effects of employee development and business ethics are the most obvious, followed by energy and resource consumption and governance system.

In other words, for industry analysts and fund managers focusing on the information transmission, software, and information technology services industry, integrating factors such as employee development and business ethics, and energy and resource consumption and governance system factors in the ESG investment integration process in this industry may enhance the risk-return characteristics of the investment portfolio, potentially leading to long-term excess returns.

Similar conclusions can be drawn for the electrical machinery and equipment, computer, communication, and other electronic equipment manufacturing industries, where the most substantive ESG issues are: energy and resource consumption, pollutant emissions, climate change adaptation, employee development, governance system, and business ethics. The transmission effects of energy and resource consumption and governance system are the most obvious, followed by pollutant emissions and climate change adaptation, and then employee development and business ethics.

The study found that among the 18 green integrated industries, on average, 75% of the future two-year transmission mechanism results of substantive issues conform to the above conclusions.