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|Title||Augmenting Factor Investment Strategies with ESG-Scores|
|Institution||University of Zurich|
|Faculty||Faculty of Business, Economics and Informatics|
|Number of Pages||86|
|Zusammenfassung||Responsible investments are one of the most popular topics currently discussed in ﬁnance. Yet, it is by no means a new ﬁeld of study, as academic research has been exploring the connection between corporate social responsi- bility (CSR) and ﬁnancial performance for over four decades. But the question of whether decision making based on ethical, societal and environmental factors can create economic beneﬁts attracts ﬁnancial institutions, asset managers and individual investors just the same. Still, there is much uncertainty concerning the ﬁnancial impacts of decisions based on CSR. In many areas of CSR-related research, neither the practical nor the academic world could reach conclusive statements. While the general conclusion of most research regarding the link between CSR and company ﬁnancial performance (CFP) is that there exists an at least modestly positive link between CSR and CFP (Friede et al. (2015)), the same link rarely applies on an aggregated portfolio level. Most strategies sorted on environmental, social governance criteria (ESG) have oﬀered no performance increases over regular strategies, and sometimes suggested that investors even have to pay a price to be invested in more sustainable companies. Further, a risk-reduction eﬀect of focusing on sustainable stocks could also not be observed (Brooks and Oikonomou (2018)). Previous research has oﬀered multiple explanations for the lack of performance in SRI-portfolios. In a literature review, Friede et al. (2015) identify three main reasons. First, overlapping eﬀects from market and non-market factors in a portfolio can cover a potentially existing ESG-alpha. Second, Derwall et al. (2011) ﬁnd diﬀerent performance eﬀects from ESG-screens which can net out when combining them in portfolios. And third, portfolio studies often involve transaction costs which might mitigate those slight positive eﬀects of CSR on the companies in the portfolio. Pizzutilo (2017) further extends the list by showing the possible negative eﬀects of having an underdiversiﬁed portfolio because of exclusionary screens which also could net out any gains from the higher CSR-levels in the portfolio. To better understand these issues on the portfolio level, and to explore how to possibly better include ESG into an existing portfolio strategy, this paper will focus on the eﬀects of ESG-sorting on elementary factor strategies, including size (SMB), value (HML), proﬁtability (RMW), investment (CMA), momentum (MOM) and short term reversal (STREV). Trying to isolate eﬀects in speciﬁc style-investments might give a better understanding which parts of a portfolio are aﬀected in which way by an ESG-sort. As previous research has shown, better CSR has an inﬂuence on various performance metrics, which in turn often are used to sort into the factor strategies. ESG-sorting was performed based on the aggregated ESG-scores from Thomson Reuters (Reﬁn-itiv). The scores included regular ESG, E, S, G as well as a Controversies score C and an aggregated ESGC score combining ESG and C. First, I established a baseline by looking at the eﬀect of ESG-sorting on the whole market. My results stay in line with prior research. First of all, good-minus-bad (sustainable-minus-unsustainable) strategies performed on a global market showed almost no stat-istical signiﬁcance, which means generally such a long-short portfolio cannot generate signiﬁcant performance. Regardless of which ESG-dimension I sorted on, a bad portfolio usually performed slightly better than a good one, providing more proof that investors have to pay a price for being invested in more sustainable companies. Furthermore, in most cases even long-only strategies could not generate signiﬁcant alpha over the market. The dataset covered over 3000 companies and during most of the time had over 1000 companies with available ESG-data. This provided a good opportunity to analyse regional diﬀerences as well. There were indeed large regional diﬀerences. In North America and the Asian/ Paciﬁc region, sustainable portfolios were more likely to have average returns above those of the unsustainable ones, while in Europe the opposite was true. Also, it could be observed that the eﬀects of sustainability sorting were much more pronounced for small companies and in those cases it was more likely that a sustain- able portfolio could create higher returns than the unsustainable. As the next step, I created the factor strategies in the same way as in prior related research Asness et al. (2019); Fama and French (2015); Jegadeesh (1990); Jegadeesh and Titman (1993) and sorted using the ESG-scores on top of the factor legs, thus separating every factor leg into sustainable and unsustainable. Unsurprisingly, most factors were aﬀected diﬀerently by the inclusion of ESG. After seeing high variability in ESG-sorted long-short strategies, I looked at the diﬀerent factor legs separately. Almost no ESG-sorted long leg outperformed the unsorted one but rather they underper-formed or were very similar to the regular legs. The only signiﬁ- cantly better long leg was found in the sustainable STREV. Short legs varied more. Key ﬁndings were that a portfolio of unsustainable (CMA), momentum (MOM) and short term reversal (STREV). Trying to isolate eﬀects in speciﬁc style-investments might give a better under- standing which parts of a portfolio are aﬀected in which way by an ESG-sort. As previous research has shown, better CSR has an inﬂuence on various performance metrics, which in turn often are used to sort into the factor strategies.|