For those who went through the explosion of “factor” indexes, the impact of 2022 on ESG portfolios won’t be surprising – finance professionals are well aware that a factor works well until the very moment it doesn’t.
As with any factor, an investor needs to focus not just on the part that may outperform, but also on the flip-side. The famous Fama-French factors have been built as a set of complementary portfolios.
This is also precisely why CRSP created a set of paired indexes – CRSP ISS ESG Indexes – to provide investors with the insight of how ESG and non-ESG portfolios performing in an unbiased, transparent, and complete picture.
For the past 7 years, portfolios of ESG-qualifying companies generally outperformed those of non-qualifying ESG constituents by an average of 2%-7% a year. This outperformance cannot be completely explained by sector performance differential. Even when Technology and Healthcare, which are generally ranked higher in ESG scores, underperformed Energy and Consumer Discretionary, which are generally ranked lower in ESG scores, ESG-qualifying portfolios still outperformed in 2016, 2019, 2020 and 2021.
CRSP U.S. Large Cap: Annual Performance Differential of ESG and Non-ESG Complements
Note: Data as of 12/30/2022; returns computation is based on total returns; Prior to 9/7/2021 the CRSP ISS ESG Indexes return series is based on a backtest; CRSP US Sector Indexes total returns are for constrained indexes, meaning that securities’ weights within sector indexes are adjusted to comply with IRS Regulated Investment Company rules. CRSP U.S. Sector Indexes based on Enhanced FTSE ICB® (EICB) methodology are used for returns after 6/7/2020; CRSP U.S. Sector Indexes based on FTSE ICB® methodology are used for returns prior to 6/5/2020. For more details on pairing between EICB-based and ICB-based CRSP U.S. Sector Indexes refer to our white paper and public announcement.
2022 does not usher in the end of ESG as a factor journey. As ESG data continues to evolve, with companies disclosing more information about their non-financial performance, the accuracy and comprehensiveness of the scores should improve. Furthermore, despite a tremendous underperformance in 2022, a model created and maintained by CRSP Market Indexes (CRSPMI) still indicates a positive association between portfolio’s ESG score and performance, with the CRSP ISS ESG Prime Index having a statistically significant and positive alpha.
There is one key lesson that 2022 should reinforce – fully understand the behavior of your factor. This means understand the impact of the ESG score on inclusion or exclusion of the company from the portfolio, understand the behavior of ESG but also the non-ESG portfolios. In short, as an investor you have to use benchmarks that are transparent, unbiased, and complete. Read our ESG white paper for more.
Fama-French 5 Factor Model for CRSP ISS ESG Indexes
Note: Data for period 1/1/2015 – 12/30/2022; monthly total returns are used in robust regression; Prior to 9/7/2021 the CRSP ISS ESG Indexes return series is based on a backtest; bold font indicates coefficients statistically significant at alpha 10%
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2022: The Year of Questioning ESG
For those who went through the explosion of “factor” indexes, the impact of 2022 on ESG portfolios won’t be surprising – finance professionals are well aware that a factor works well until the very moment it doesn’t.
As with any factor, an investor needs to focus not just on the part that may outperform, but also on the flip-side. The famous Fama-French factors have been built as a set of complementary portfolios.
This is also precisely why CRSP created a set of paired indexes – CRSP ISS ESG Indexes – to provide investors with the insight of how ESG and non-ESG portfolios performing in an unbiased, transparent, and complete picture.
For the past 7 years, portfolios of ESG-qualifying companies generally outperformed those of non-qualifying ESG constituents by an average of 2%-7% a year. This outperformance cannot be completely explained by sector performance differential. Even when Technology and Healthcare, which are generally ranked higher in ESG scores, underperformed Energy and Consumer Discretionary, which are generally ranked lower in ESG scores, ESG-qualifying portfolios still outperformed in 2016, 2019, 2020 and 2021.
CRSP U.S. Large Cap: Annual Performance Differential of ESG and Non-ESG Complements
Note: Data as of 12/30/2022; returns computation is based on total returns; Prior to 9/7/2021 the CRSP ISS ESG Indexes return series is based on a backtest; CRSP US Sector Indexes total returns are for constrained indexes, meaning that securities’ weights within sector indexes are adjusted to comply with IRS Regulated Investment Company rules. CRSP U.S. Sector Indexes based on Enhanced FTSE ICB® (EICB) methodology are used for returns after 6/7/2020; CRSP U.S. Sector Indexes based on FTSE ICB® methodology are used for returns prior to 6/5/2020. For more details on pairing between EICB-based and ICB-based CRSP U.S. Sector Indexes refer to our white paper and public announcement.
2022 does not usher in the end of ESG as a factor journey. As ESG data continues to evolve, with companies disclosing more information about their non-financial performance, the accuracy and comprehensiveness of the scores should improve. Furthermore, despite a tremendous underperformance in 2022, a model created and maintained by CRSP Market Indexes (CRSPMI) still indicates a positive association between portfolio’s ESG score and performance, with the CRSP ISS ESG Prime Index having a statistically significant and positive alpha.
There is one key lesson that 2022 should reinforce – fully understand the behavior of your factor. This means understand the impact of the ESG score on inclusion or exclusion of the company from the portfolio, understand the behavior of ESG but also the non-ESG portfolios. In short, as an investor you have to use benchmarks that are transparent, unbiased, and complete. Read our ESG white paper for more.
Fama-French 5 Factor Model for CRSP ISS ESG Indexes
Note: Data for period 1/1/2015 – 12/30/2022; monthly total returns are used in robust regression; Prior to 9/7/2021 the CRSP ISS ESG Indexes return series is based on a backtest; bold font indicates coefficients statistically significant at alpha 10%