“ESG, Fundamentals, and Stock Returns”

For decades, the delivery of wealth maximization has been paramount to investors.  More recently, ESG’s adherence to social preferences has caught investors’ interests.  But are investors who allocate capital to stocks with higher ESG ratings and shun those with lower ratings faring better?  Prior research has shown that a focus on fundamentals, particularly earnings surprises, consistently dominate relative stock performance. Put differently, there is a strong link between earnings outcomes (vs. expectations) and returns that has not weakened over time.  The same cannot be said about ESG. Using ESG metrics as a stand-alone input does not seem to help outperformance. Still, when using a quantitative framework based on Classification and Regression Trees (CART), the paper shows that there is interplay between ESG metrics and other fundamental drivers.  This piece provides valuable insights into how to integrate ESG factors into a stock selection process.  The optimal integration of ESG into a wealth maximizing objective should allow ESG factors to conditionally add returns without adversely limiting alpha potential.  This can be achieved by spending the ESG budget where the alpha confidence is weaker.  The paper further concludes that without a quantitative framework, ESG is more likely to act as a constraint that leads to lower average returns.