In recent years, ESG investing has gained significant traction in the world of finance. Investors are increasingly looking beyond traditional financial metrics to assess the sustainability and ethical practices of the companies in which they invest. ESG scores have emerged as a tool for evaluating a company’s performance in these areas as well as serving as a tool for risk management. In this blog post, we’ll delve into what ESG scores represent, highlight the results and importance of backtesting these scores, and investigate what is potentially driving those results.
ESG Scoring, a Financial Materiality Framework
ESG scores provide a quantitative representation of a company’s environmental, social, and governance performance, which can have an impact on a company’s financial performance and risk profile. Bloomberg provides ESG Scores, which are based on financial materiality and are fully data-driven and transparent with a framework and methodology that is accessible to customers. Bloomberg’s E and S scores focus on industry-specific issues that drive financial impact, while our governance scores incorporate certain country-specific policies and practices. The below charts show the coverage and distribution of Bloomberg’s ESG scores.
Measure financial materiality with backtesting
Assessing the potential impact of ESG scores on investment outcomes can shed light on how ESG factors correlate with financial performance and how they can be used as a risk management tool.
Figure 3 shows the results of Bloomberg backtesting its ESG scores during the period 2016-2023, when the focus on ESG took off. To conduct the backtesting, we ranked the companies of the Bloomberg World Large & Mid Cap Index (WORLD Index) according to their Bloomberg ESG score, which ranges from 0 to 10. We then separated those companies in two categories: top 80 percentile and bottom 20 percentile based on their ESG score*. The rationale for this split aligns with a risk management approach for ESG to measure and understand how ESG laggards perform compared to the rest of the investment universe. An ESG portfolio that follows this kind of split is rebalanced on a yearly basis to account for the improvement/deterioration of ESG performance over time.
As we can see in Figure 3, the bottom 20% of companies in terms of ESG scores tend to consistently underperform the top 80% of companies in that period (2016-2023). This provides some support for the idea that investors’ investment into low-scoring ESG stocks may have some impact on performance compared to the rest of the universe. Obviously, this can vary in time, in geographic areas as well as the sectors considered – and does not constitute any guarantee for the future – but overall, the trend during this period is quite significant.
This indicates that by integrating ESG factors, investors could potentially see enhanced returns while managing risk, lending support to the idea that ESG factors are not merely a trend but an effective investment strategy.
What are the main drivers of these results?
When analyzing backtesting results, one should question the origins of performance. We checked the correlation of our backtesting result with standard equity factors using Bloomberg factors: market beta, value, growth, momentum, profitability, volatility, and size.
Our finding, as indicated by Figure 4, shows a high correlation of an ESG Portfolio (80% high-scoring versus 20% low-scoring ESG stocks) with the market, which means we need to neutralize this to see the actual performance of the ESG factor.
To do so, we ran a multi-variable regression to subtract any equity factors from the equation. Figure 5 shows the results: even after accounting for any classic equity factor, ESG Long-Short is still performing consistently well, meaning that low-scoring ESG companies tend to underperform the rest of the universe.
Bloomberg
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