Volatility and Risk-Adjusted Returns of ESG Indices: Comparison
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Please note this is a comparison between Version 2 by Jessie Wu and Version 1 by Rashmi Chaudhary.

The importance of Environmental, Social, and Governance (ESG) aspects in investment decisions has grown significantly in today’s volatile financial market. This study aims to aEnswer the important question of whether investing in ESG-compliant companies is a better option for investors in both developed and emerging markets. This study assesses ESG investment performance in diverse regions, focusing on developed markets with high GDP, specifically the USA, Germany, and Japan, alongside emerging nations, India, Brazil, and China. We compare ESG indices against respective broad market indices, all comprising large and mid-cap stocks. This study employs a variety of risk-adjusted criteria to systematically compare the performance of ESG indices against broad market indices. The evaluation also delves into downside volatility, a crucial factor for portfolio growth. It also explores how news events impact ESG and market indices in developed and emerging economies using the EGARCH model. The findings show that, daily, there is no significant difference in returns between ESG and conventional indices. However, when assessing one-year rolling returns, ESG indices outperform the overall market indices in all countries except Brazil, exhibiting positive alpha and offering better risk-adjusted returns. ESG portfolios also provide more downside risk protection, with higher upside beta than downside beta in most countries (except the USA and India). Furthermore, negative news has a milder impact on the volatility of ESG indices in all of the studied countries except for Germany. This suggests that designing a portfolio based on ESG-compliant companies could be a prudent choice for investors, as it yields relatively better risk-adjusted returns compared to the respective market indices. Furthermore, there is insufficient evidence to definitively establish that the performance of ESG indices varies significantly between developed and emerging markets.vironmental, Social, and Governance (ESG) investing has emerged as a prominent investment strategy, garnering widespread attention. 

  • ESG investing
  • downside risk
  • asymmetric volatility
  • risk-adjusted returns

1. Introduction

As investors increasingly recognize the importance of these elements for long-term profitability and sustainability, the popularity of environmental, social, and governance (ESG) investing has surged (Park and Jang 2021; Van Duuren et al. 2016). ESG investing offers investors the opportunity to align their financial interests with their ethical values, supporting companies committed to sustainability and ethical business practices (Brest et al. 2018). However, a crucial question arises: Does ESG investing truly offer a favorable risk–reward ratio, or is it merely a form of “greenwashing” and a marketing gimmick?
Previous research has delved into the connection between ESG performance and financial results, but the findings have frequently been inconclusive, with some indicating a positive impact while others show no discernible influence on performance (Naeem et al. 2022; Whieldon and Clark 2021; Sudha 2015; Jain et al. 2019; Ouchen 2022). One key challenge is the lack of standardized ESG principles, which makes it difficult for investors to compare companies and funds. Additionally, critics argue that ESG investing may limit investment opportunities and potentially result in lower returns, as even companies with subpar ESG performance can exhibit strong financial performance. The performance of ESG indices in terms of risk and return is a dynamic and evolving phenomenon influenced by various factors, including the maturity of the economy, the regulatory environment, and the commitment of companies to sustainability. In developed economies, ESG indices have demonstrated their ability to deliver competitive returns while managing risks effectively. In developing economies, ESG investments show promise, but challenges related to volatility and limited ESG disclosure must be considered (Al Amosh and Khatib 2023; Singhania and Saini 2023).

2. Environmental, Social, and Governance Investing 

The popularity and growth of ESG (Environmental, Social, and Governance) investing globally are remarkable. Many studies have contrasted the traditional index with the ESG index for various geographical regions and looked at the connection between ESG and business financial performance. A set of studies has been carried out to compare the conventional portfolios with the ESG portfolios. One study conducted by Ouchen (2022) analyzed the performance of the MSCI USA ESG Select compared to the S&P 500 from 2005 to 2020. The study found a positive impact of ESG investments on performance and risk reduction. In the Indian context, Sudha (2015) found no statistical difference in the returns of ESG and broad-based indices but observed that the ESG India Index was less volatile from 2005 to 2012. Jain et al. (2019) compared the ESG and conventional index of developed and emerging markets as a whole and not country-specific, finding no significant difference in performance. Liu et al. (2023) assert that incorporating ESG indices into an investment portfolio offers the advantage of diversification, a principle aligned with modern portfolio theory that effectively lowers overall portfolio risk. ESG factors assume a pivotal role in diversification by mitigating idiosyncratic risks. Additionally, ESG factors may influence a company’s systematic risk (beta). Companies with poor ESG practices may face higher systematic risks due to regulatory changes, climate-related events, or shifts in consumer preferences. Hartzmark and Sussman (2019) found that stocks with higher sustainability rankings had higher valuations, suggesting that investors consider ESG factors when pricing assets. Friede et al. (2015) found a positive correlation between ESG factors and financial performance in most cases. This suggests that integrating ESG considerations can lead to better risk-adjusted returns. Several studies found that ESG investing can offer downside protection during market downturns, which is an important consideration for investors seeking to manage risk in their portfolios (Albuquerque et al. 2020; Broadstock et al. 2021; Engelhardt et al. 2021; Lau 2019). On the other hand, several studies indicate that ESG investment is not necessarily a surefire strategy to perform better during a crisis (Abedifar et al. 2023; Folger-Laronde et al. 2022). Also, Lashkaripour (2023) analyzed that high ESG stocks have higher tail risk compared to low ESG stocks during a market crash. Revelli and Viviani (2015), based on a meta-analysis of 85 studies and 190 tests, have suggested that incorporating corporate social responsibility into stock market portfolios does not confer a distinct advantage or disadvantage relative to traditional investments. Bannier et al. (2023) investigated the returns of US firms from 2003 to 2017 and discovered that the return decreased more strongly than the corresponding risk with increasing corporate social responsibility activity. Most studies that have looked at the connection between ESG and corporate financial performance have discovered a positive correlation, though the strength of this correlation varies depending on the ESG factors considered, industry sector, and geographic location of the companies (Suresha et al. 2022; Kim and Li 2021; Dalal and Thaker 2019; Zhao et al. 2018). Edmans (2023) mentioned in his research that ESG is both extremely important and nothing special. It is important not to excessively applaud companies solely for enhancing their ESG performance, as compared to other intangible aspects. ESG factors play a crucial role in determining a company’s long-term financial value. Evaluating a company’s long-term prospects and considering various factors beyond short-term financial gains is not exclusive to ESG investing; rather, it constitutes fundamental investing practices. The term “ESG investing” can be misleading, as it is more accurate to describe it as “ESG analysis.” The process involves thoroughly assessing Environmental, Social, and Governance factors to gain a comprehensive understanding of a company’s overall performance and potential risks and opportunities. Singhania and Saini (2023) highlight that ESG disclosure in both developed and emerging markets is driven by a combination of voluntary and mandatory codes, with an emphasis on environmental commitment. Their study suggests that comprehensive governance measures, including sustainability reporting and integrated reporting, are crucial to uplift ESG practices. These practices, when adopted, can bridge the gap between unsustainability and sustainability, potentially impacting risk-adjusted returns positively by reducing information asymmetry and enhancing resilience in business operations. With inconclusive results and limited exploration of all geographies, there is a need to understand the risk and return dynamics between sustainable and conventional indices. The variation in ESG disclosures may result in differing performance outcomes for ESG-focused companies in developed and emerging markets. Thus, this restudyearch aims to assess the performance of ESG indices in comparison to broad-based indices investments across different geographical regions, encompassing both developed and emerging markets with significant GDP. WeResearchers conduct a comprehensive analysis of the performance of ESG indices relative to broad-based indices investments in key countries, including the United States, Germany, and Japan, representing the developed economies, and India, Brazil, and China, representing emerging economies. This studyresearch uses various risk-adjusted measures and captures downside volatility for evaluating the performance of ESG indices with respect to the broad market indices of that respective country. The conditional volatility of indices is measured through ARCH-GARCH analysis. The impact of news on ESG indices as compared to market indices is also captured in both developed and emerging markets. Through this comprehensive examination across different geographies, weresearchers aim to provide a thorough understanding of the risk–return profile of ESG investments relative to broad-based indices investments in both developed and emerging markets.

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