A Firm’s Engagement in Environmental, Social and Governance (ESG) Issues and its Effect on Portfolio Returns

Abstract

This thesis examines how a firm’s engagement in environmental, social and governance (ESG) issues affect portfolio returns, which in previous research have resulted in contradicting results. By using the improved Fama and French five-factor model and ESG dataset from Sustainalytics that report both the total ESG score, the individual scores of E, S and G and adjust the ESG issues depending on the sector, this thesis’s result will be more accurate than previous research using a similar approach. I show that a portfolio only consisting of firms that report ESG independent of level of engagement generates a positive alpha of 8.1% annually compared with the US stock market. By only investing in firms that are top ESG performers the annual alpha will drop to 2.7%. Firms that are top performers in one of the environmental, social or governance areas will not generate any alpha, but an above average engagement in these issues excluding the top performers will generate an annual alpha of 3.7%, 5.7% and 5.0% respectively. Therefore, I propose that investors should invest in firms engaging in ESG issues to increase portfolio return, but too much engagement in all of these areas or in one particular area will lead to diminishing positive effect on portfolio return or no increase in portfolio return at all.