Do ESG-Scores Explain Returns in the U.S. Equity Market? Incorporating ESG-Scores within a Multi-Factor Framework

Abstract

In an era where sustainable investing endorses both ethical alignment and economic promise, a critical question remains: do firms with stronger ESG-incentives actually yield greater stock returns? This thesis explores that topic in the U.S. stock market. Building on established multi-factor asset pricing models, the study incorporates ESG-scores into the models, in order to determine whether sustainability influences asset pricing. Using data from 467 firms, ranging from 2010 through 2023, the thesis uses rigorous methods, such as ordinary least squares regression, Fama-MacBeth two-stage regression, and Gibbons, Ross, and Shanken test, in order to assess ESG’s role in return variation. The results indicate a subtle trend in that integrating ESG-scores into traditional multi-factor models moderately enhances the explanatory power, suggesting that ESG carries some informational weight, however, the models often fall short in delivering consistent statistical significant variables. In essence, ESG-leaders did not reliably outperform ESG-laggards, based on the findings in this thesis. This outcome indicates that, at least within the U.S. equity market the last few decades, strong sustainable and ethical performances have not automatically translated into outperformance in stock returns. It highlights the notion that ESG-investing may suggest an emphasis on values over value, and leaves the door open for further debate on when, or even if, the market will price sustainable incentives.