A recent study by MIT’s Sloan School of Management proposes that combining different ESG indices could provide a possible solution to the inconsistent standards adopted by environmental, social, and governance index providers, and generate better ESG returns. The study examined six index providers: MSCI, S&P Global, ISS, Moody’s ESG Solutions, RepRisk, and TruValue Labs. From 2014 to 2020, individual ESG indices generated average annual excess returns of 4.8%, 2.9%, and 9% in the United States, Europe, and Japan, respectively.
However, the MIT researchers found that merging the ESG indices using different aggregation methods can generate significantly higher returns. According to the paper, when combined, the six indices achieved excess returns of 6% in the US and Europe and 9.6% in Japan.
Empirically, we find significant ESG excess returns in the U.S. and Japan. We also find positive and higher than market risk-adjusted returns.”
Massachusetts Institute of Technology (MIT) – Sloan School of Management
Florian Berg, a research scientist at MIT Sloan School of Management and one of the paper’s authors, explained that diversifying the source of ESG ratings is helpful. By combining ESG ratings from different providers, investors can reduce the noise level of each provider. The simplest aggregation method, which assigns equal weight to the various ESG indices, for instance, generated an excess return of 7.7% in the US when applied to a portfolio that is long the stocks in the top quartile of ESG ratings and short the stocks in the bottom quartile.
One practical implication from our results is that aggregation methods help to reduce the noise and amplify the signal contained in E, S, and G metrics to yield better estimates of ESG portfolio properties.”
Massachusetts Institute of Technology (MIT) – Sloan School of Management
The paper’s findings show that ESG investing does generate excess returns over the market, although the returns vary widely across different index providers. “The choice of different data methodologies and sources can lead to a substantial divergence between rating providers,” the paper noted. “This raises the question [of] whether ESG ratings are in fact useful for portfolio construction, and if so, how to optimally exploit the signal in ESG ratings, despite their noisy nature.”
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