Eliminating the 10 percent of stocks with lowest ESG ratings also lowers portfolio volatility, according to analysis
Investors can improve their returns and lower the volatility of their portfolios by eliminating the stocks with the lowest ESG ratings, according to a study by asset management firm New Amsterdam Partners.
The study, which analyzes returns over the past six years in the US, also shows that eliminating the stocks with the lowest ESG ratings can reduce the overall volatility of an investor’s portfolio, say authors Indrani De and Michelle Clayman.
‘We found a strong association between ESG ratings and portfolio performance,’ the authors write in the study. ‘An active manager seeking the [truly] out-performing stocks can improve the probability of doing so by eliminating the lower tail ESG stocks. It is also logical to think of low-ESG rated stocks as potentially (lower) tail investment-risk companies, and we find that eliminating the lower tail ESG companies tends to reduce portfolio volatility.’
For the study, the authors created 40 sample portfolios of 100 randomly selected US stocks and gave an equal rating to each stock within each portfolio. They then created 40 more sample portfolios identical to the first lot but removed the 10 percent of stocks with the lowest ESG ratings, as determined by the Thomson Reuters Corporate Responsibility Ratings.
The authors find the mean returns for the portfolios that eliminated the lowest-rated ESG stocks are better than those of the other set in five of the past six years. The only year in which this is not the case is 2007, just as the financial crisis was getting underway.
‘The correlation between ESG ratings and risk-adjusted return turned significantly positive in recent years and this positive correlation is strengthened by excluding the lowest ESG stocks,’ the authors conclude.
