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ESG – momentum is all that counts

The extent to which a company adheres to ESG-criteria does not materially impact stock returns. However, changes in ESG scores can tell you something about future return potential of a stock, according to new research commissioned by NN Investment Partners.


PA Europe

The study, which was performed by the European centre for Corporate Engagement of Maastricht University (Netherlands) is based on ESG data for 3000 listed companies in developed markets. It didn’t find a straightforward relationship between a company’s risk-adjusted return and the way it manages environmental, sustainability and governance factors.

However, it showed that the Sharpe ratio of a portfolio improves if it is long stocks that are in the process of improving their ESG-scores and short companies that have weakest momentum (i.e. showing no change), provided only companies with medium or low ESG-scores are selected (see figure 1). This is because stocks that already score high on ESG-criteria have relatively little scope to improve further.

The momentum factor even gets stronger if only stocks that score medium on corporate governance (G) are selected. A portfolio that’s long companies with strong Governance momentum and short stocks with weak Governance momentum has a Sharpe ratio of more than 1. 

The results of the study call into question the efficiency of the ESG-screening performed by most investors, who construct ESG portfolios by simply screening their universe and excluding companies below a certain ESG-score.

However, there is something to this too, as screening also helps to improve risk-adjusted performance, albeit only by excluding companies that have significant, high or severe ESG controversies (cat. 3+; see figure 2). Such a measure leads to a 10% increase in the Sharpe ratio of the portfolio, the research shows.

Morningstar, the investment research and data provider, has also provided evidence that ESG-screening helps mutual fund performance.

It has recently started assigning sustainability scores to funds, in addition to its long-standing star-ratings, using data from Sustainalytics, the firm which also provided data for the NN IP study. It turns out that funds with only 1-globe rating (the lowest possible sustainability score) are twice as likely to have a 1-star rating than to have a 5-star rating (the maximum risk-adjusted performance score).

“Even though you can’t really compare globe-ratings to star-ratings, because the former are just a snapshot based on their most recent portfolio while the latter are based on a fund’s long-time track record, it’s obvious that there are more 5-star funds that score high on sustainability and more 1-star funds that score low,” says Jon Hale, head of sustainability research at Morningstar.