Integration of ESG in Asset Allocation

Abstract

In this paper, we try to identify the relationship between the ESG scores and stocks' performance and risk measures. Using the ESG database of MSCI, we split the global investment universe into three regions: Europe, North America and Asia-Pacific. The investment universe of each region is defined by the components of the corresponding MSCI index which is rebalanced every month. A simple statistical check allows us to verify the integrity of the database. For the portfolio construction of E/S/G/ESG factors, the ESG scores are normalized for all stocks in the same sector such that the sectorial bias is minimized. We find that Governance score can significantly improve the portfolio's performance both in Europe and North America, meanwhile, the market of Asia-Pacific is not sensitive to E/S/G/ESG scores. It is interesting to remark that the Governance factor in Europe can be explained by traditional Quality factor, meaning that there is some equivalence between Governance score and Quality indicators. In terms of risk measures, we observe that stocks with higher Governance and Environmental scores are exposed to lower risks measured by maximum drawdown or volatility, for Europe and North America. In Asia-Pacific, it is difficult to make any conclusion on the relationship between risk measures and ESG scores.

Keywords: Socially Responsible Investment, ESG, Factor Investing

JEL Classification: C50, C60, G11