Combining Momentum and ESG Ratings Enhances Performance
Investing based on environmental, social and governance (ESG) concerns should lead to lower returns, since the prices of those stocks will be bid up beyond their intrinsic value. But new research shows that by combining ESG- and momentum-based principles, investors can achieve higher risk-adjusted returns.
The increased popularity of ESG investing has been accompanied by heightened research into the subject. Matus Padysak contributes to the literature with his August 2020 paper, “ESG Scores and Price Momentum Are More Than Compatible.” Using optimization tools, he examined whether you could enhance the classic momentum strategy by making it more sustainable (weighting the momentum portfolio toward firms with positive momentum in their ESG scores). He also examined whether you could enhance an ESG strategy by weighting it toward stocks with positive momentum. ESG scores were from OWL Analytics. The dataset contained 691 U.S. stocks and covered the period April 2010 through October 2019. Portfolios were long only. Following is a summary of his findings:
- A combined strategy that selects stocks with the highest momentum while maximizing ESG scores of the portfolios results in momentum portfolios that are significantly more responsible, with lower volatility and better risk-adjusted returns.
- A combined strategy that selects stocks with the highest ESG scores while maximizing momentum at the same time results in a more profitable ESG portfolio.
- The combined ESG-momentum strategy has the best risk-adjusted return, the lowest drawdown, the lowest volatility and the most consistent returns.
- Relative to the CAPM (market beta), the Fama and French three-factor (market beta, size and value) model, and the Fama and French five-factor (adding investment and profitability) model, the strategies have both economically and statistically significant (at the 1% confidence level) alphas – common market factors cannot explain performance.
The following table shows the results using the top 10% of stocks:
For the top 15% of stocks, the results were similar: