ESG investing in Equity Country Selection

Lina Nassar, PhD
ESG investing, sustainable investing, country ESG, ESG Momentum, Combined ESG, equity country selection, factor investing, sovereign ESG, equity country selection strategies, country asset allocation, cross-section of country returns.

Abstract :

The Role of Firm-level ESG and ESG Momentum in the Predictability of Cross-sectional Country Returns: Recent years have witnessed a rise in Environmental, Social and Governance (ESG) investing across global markets and asset classes. While this has spurred a growing body of literature on the topic, existing empirical studies have focused on the stock level in the equities space, leaving the application of ESG investing to cross-country equity allocation unexplored. Considering the vast opportunities associated with country-level asset allocation supported by the rise of passive investments and ETFs, it is imperative to extend the literature on ESG investing to this space, in order to enable the incorporation of ESG considerations in country allocation strategies, as part of a wider effort to provide investment guidance on ESG investing in all asset classes and approaches to investing. This paper is the first to comprehensively examine the relationship between firm-level ESG scores aggregated to the country-level and cross-sectional country returns. The findings show that countries populated with firms that exhibit better ESG practices significantly outperform countries with worst firm-level ESG practices. Furthermore, the paper examines the effect of “ESG Momentum” - a country’s change in its firm-level ESG profile, finding that markets with improving ESG practices - positive ESG Momentum, significantly outperform those with negative ESG Momentum. Incorporating both the level and momentum of ESG attributes markedly improves returns, demonstrating statistical significance in both developed and emerging markets. These results are robust to country equity factors as well as stock Fama and French factors. The paper proceeds to measure the impact of incorporating ESG considerations on the investment returns of a cross-country equity allocation model, demonstrating that the portfolio’s ESG exposure can be increased and the financial returns improved. The results of this analysis are consistent with the growing empirical literature that documents a positive association between ESG attributes and financial performance.

Integrating Country ESG with Factor Investing in Equity Country Selection:  Environmental, Social, and Governance (ESG) attributes on the country-level include indicators such as CO2 Emissions and Environmental Regulatory Framework (in the Environmental dimension), Healthcare Capacity and Women’s Rights (in the Social dimension), and Political Risk and Investor Protection (in the Governance dimension). While there exist empirical studies that test the relationship between a range of country Governance attributes and national stock market performance, there are hardly any studies that test this relationship using Environmental, Social or overall ESG attributes. Topical global challenges, such as the Covid-19 pandemic and rising Environmental concerns, have brought the relevance of these matters into the spotlight and whilst these challenges are global in nature, countries continue to respond differently in efforts to address and mitigate them. The motivation of this research paper is to undertake a thorough analysis of the relationship between a country’s ESG profile and the financial performance of its equity market. In particular, the paper intends to explore whether this relationship could be translated into a profitable country selection strategy built on the paradigm of factor investing. The research finds that in developed markets, ESG attributes are associated with positive financial performance, exhibiting Sharpe ratios greater than that of standard country equity factors including value, momentum, size and quality. This effect translates into superior returns from integrating ESG considerations with factor investing in a country selection strategy. The findings are more mixed in the emerging markets sample. While the Environmental factor exhibits positive returns, the Social and Governance factors demonstrate negative returns, most pronounced in the robustness tests where country-selection factors and an Economics control variable are included in the regressions. The excess return lost from not investing in countries ranking lowest on Social and Governance attributes is perceived to be the cost of ESG investing. This translates into a cost to financial performance, largest when the country selection strategy is tilted to Governance attributes. However, a more holistic approach of ESG-integration using the overall ESG factor exhibits a substantial enhancement in the ESG tilt of the portfolio without an impediment to returns. In exploring the link between firm-level ESG attributes and country-level ESG attributes, the research finds that in developed markets, incorporating country ESG attributes alongside firm ESG level and momentum factors produces the strongest returns, while in emerging markets integrating firm ESG level and momentum factors alone is most profitable.


Publication date of the thesis

Thesis committee

Supervisor: Lionel Martellini, EDHEC Business School 

External reviewer: Sudheer Chava, Georgia State University  

Other committee members: Emmanuel Jurczenko and Enrique Schroth, EDHEC Business School