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Environmental, social, and governance (ESG) investing is a very broad field with many different investment approaches addressing various investment objectives. At a top level, we can break down ESG investing into three main areas that each have their own investment objective: First, ESG integration, in which the key objective is to improve the risk–return characteristics of a portfolio. Second, values-based investing, in which the investor seeks to align his portfolio with his norms and beliefs. Third, impact investing, in which investors want to use their capital to trigger change for social or environmental purposes, for example, to accelerate the decarbonization of the economy. In this article, we focus on the first investment objective—ESG as a means to achieve financial objectives in portfolio management.
In recent years, many researchers from both academia and the asset management industry have analyzed the relationship between the ESG profile of companies and their financial risk and performance characteristics. In fact, research has been so plentiful that several meta studies1 have summarized the results of over 1,000 research reports and found that the correlation between ESG characteristics and financial performance was inconclusive: The existing literature found positive, negative, and nonexistent correlations between ESG and financial performance, although the majority of researchers found a positive correlation.
The reasons for these inconclusive results likely stems from the different underlying ESG data used and the varying methodologies applied, especially in how far they control for common factor exposures. However, even researchers finding a positive correlation between ESG and financial performance often fail to explain the economic mechanism that led to better performance, as they typically focused on historical data analysis. A paper by Harvey, Liu, and Zhu (2016) highlights that this type of purely data-focused research entails the risk of correlation mining, that is, overfitting a financial model to a specific dataset to observe correlations that will not prevail when tested out of sample.
Another criticism mentioned in a paper by Krueger (2015) is the fact that many empirical studies analyzing the link between ESG and financial performance do not strictly differentiate between correlation and causality. Often, a correlation between ESG and financial variables is implicitly interpreted to mean that ESG is the cause and financial value the effect, although the transmission...