When the Japanese stock market meets COVID-19: Impact of ownership,China and US exposure,and ESG channels

We identify factors affecting the Japanese stock market during the COVID-19 pandemic period. First, we focus on the ownership structure. We find that indirect ownership through the exchange-traded fund purchasing program by the Bank of Japan has a positive impact on abnormal returns. Foreign ownership is negatively associated with abnormal returns, whereas ownership by traditional business groups is positively associated with abnormal returns. Second, we examine the impact of global value chains and find that stock returns are lower for companies with China and U.S. exposure. Third, in terms of environmental, social, and governance (ESG) engagement, there is no evidence that firms that have highly rated ESG scores have higher abnormal returns, but firms with ESG funds outperform those without.     

ESG Integration in Investment Management: Myths and Realities

The number of public companies reporting ESG information grew from fewer than 20 in the early 1990s to 8,500 by 2014. Moreover, by the end of 2014, over 1,400 institutional investors that manage some $60 trillion in assets had signed the UN Principles for Responsible Investment (UNPRI). Nevertheless, companies with high ESG “scores” have continued to be viewed by mainstream investors as unlikely to produce competitive shareholder returns, in part because of the findings of older studies showing low returns from the social responsibility investing of the 1990s. But studies of more recent periods suggest that companies with significant ESG programs have actually outperformed their competitors in a number of important ways. The authors’ aim in this article is to set the record straight on the financial performance of sustainable investing while also correcting a number of other widespread misconceptions about this rapidly growing set of principles and methods: Myth Number 1: ESG programs reduce returns on capital and long‐run shareholder value. Reality: Companies committed to ESG are finding competitive advantages in product, labor, and capital markets; and portfolios that have integrated “material” ESG metrics have provided average returns to their investors that are superior to those of conventional portfolios, while exhibiting lower risk. Myth Number 2: ESG is already well integrated into mainstream investment management. Reality: The UNPRI signatories have committed themselves only to adhering to a set of principles for responsible investment, a standard that falls well short of integrating ESG considerations into their investment decisions. Myth Number 3: Companies cannot influence the kind of shareholders who buy their shares, and corporate managers must often sacrifice sustainability goals to meet the quarterly earnings targets of increasingly short‐term‐oriented investors. Reality: Companies that pursue major sustainability initiatives, and publicize them in integrated reports and other communications with investors, have also generally succeeded in attracting disproportionate numbers of longer‐term shareholders. Myth Number 4: ESG data for fundamental analysis is scarce and unreliable. Reality: Thanks to the efforts of reporting and investor organizations such as SASB and Ceres, and of CDP data providers like Bloomberg and MSCI, much more “value‐relevant” ESG data on companies has become available in the past ten years. Myth Number 5: ESG adds value almost entirely by limiting risks. Reality: Along with lower risk and a lower cost of capital, companies with high ESG scores have also experienced increases in operating efficiency and expansions into new markets. Myth Number 6: Consideration of ESG factors might create a conflict with fiduciary duty for some investors. Reality: Many ESG factors have been shown to have positive correlations with corporate financial performance and value, prompting ERISA in 2015 to reverse its earlier instructions to pension funds about the legitimacy of taking account of “non‐financial” considerations when investing in companies.     

ESG for All? The Impact of ESG Screening on Return,Risk, and Diversification

A large body of research has documented a positive relationship between different measures of sustainability—such as indicators of employee satisfaction and effective corporate governance—and corporate financial performance. Nevertheless, many investors still struggle to quantify the value of ESG to investment performance. To address this issue, the authors tested the effects of using different ESG filters on an investable universe that serves as the starting point for a fund manager. In this way, they attempted to determine the extent to which ESG data can add value to any investment approach, regardless of preferences towards sustainable investing. The authors report “an unequivocally positive” contribution to risk‐adjusted returns when using a 10% best‐in‐class ESG screening approach (one that effectively removes companies with the lowest 10% of ESG rankings), both on a global and a developed markets universe. More specifically, as a result of such screening, both the global and developed markets portfolios show higher returns, lower (tail) risk, and no significant reduction of diversification potential despite the reduction in the number of companies. Use of a 25% screening filter was also found to add value, especially by reducing tail risks, but with a larger deviation from the unscreened universe. Overall, then, the authors’ finding is that the incorporation of ESG information contributes to better decision‐making in every investment approach, with the optimal configuration depending on a fund manager's preferences and willingness to deviate from an unscreened benchmark.     

The end of ESG

ESG is both extremely important and nothing special. It's extremely important because it's critical to long-term value, and so any academic or practitioner should take it seriously, not just those with “ESG” in their research interests or job title. Thus, ESG doesn't need a specialized term, as that implies it's niche—considering long-term factors isn't ESG investing; it's investing. It's nothing special since it's no better or worse than other intangible assets that create long-term financial and social returns, such as management quality, corporate culture, and innovative capability. Companies shouldn't be praised more for improving their ESG performance than these other intangibles; investor engagement on ESG factors shouldn't be put on a pedestal compared to engagement on other value drivers. We want great companies, not just companies that are great at ESG.     

The ESG Integration Paradox

Today, most investment managers have something to say about environmental, social and governance (ESG) issues, and written ESG policies are ubiquitous. Yet, a written policy is not a reliable indicator of a firm's commitment. Actual ESG incorporation practices vary greatly, with most investment managers falling well short of full integration. Only a few firms seem to be using ESG factors to deliver alpha, hence, the paradox. If not implemented wholeheartedly, responsible investing can lead to lower financial returns. So, why have so few investment managers gone all the way? The paradox involves a “valley” of lower returns where portfolios first absorb the costs of ESG integration before the promised benefits materialize. In the early days of ethical investing, the focus was on using negative screens to exclude certain companies for moral or ethical reasons but lower financial returns are inherent to exclusionary screening. Hard exclusions force managers to tradeoff certain risks for others. So, for example, if the market discounts tobacco stock prices to account for changing consumer behavior, eventually tobacco stock prices become attractive again as, indeed, has been the case over the last two decades. Exclusionary screening alone is a self‐limiting strategy. By contrast, ESG strategies range from active ownership and engagement, to positive screening (selecting for certain attributes), to relative weighting (sometimes called “best‐in‐class selection”), to risk factor investing, to full integration. Because the relationship between an asset manager's ESG efforts and its risk‐adjusted performance is not classically linear, asset owners should look for managers that are on the upward slope of the ESG intensity curve and are fully committed to advancing up it.     

Environmental,social, and governance premium in Chinese stock markets

Financial markets have increasingly adopted the concept of ESG (environmental, social, and governance); this paper studies the evolving effect of corporate ESG performance on the stock returns in China's stock markets. Utilizing the Paris Agreement and China's President Xi's pledge to achieve carbon neutrality by 2060 as ESG shocks, we find that firms with lower ESG scores provide higher stock returns after the announcement of the Paris Agreement. Furthermore, the effect of ESG performance heightens after Xi's pledge. Using sorted portfolios and Fama–French factor models, we find that investors are rewarded for bearing ESG-related risks. Our estimated monthly ESG risk premium is between 0.52% and 0.61%, while state-owned firms with larger market capitalizations and better financial and operational performance tend to have better ESG performance.     

Embedding Sustainability Performance and Long‐Term Strategy in the Earnings Call

The practice of disclosing corporate Environmental, Social and Governance performance information continues to evolve, and the frequency of ESG disclosures in investor‐facing discussions, including Investor Day presentations and non‐deal roadshows, continues to grow. But even with these developments, the corporate‐investor dialogue about ESG and long‐term strategy, and their expected effects on long‐run profitability and value, has continued to lag. This seems particularly evident in the quarterly earnings call. In this article, the authors review the work of NYU's Center for Sustainable Business, in collaboration with Chief Executives for Corporate Purpose (CECP), in encouraging companies to work ESG themes and performance into their quarterly earnings calls. After discussing the reasons for the relatively slow progress in this important disclosure venue, including interviews with sell‐side analysts, the authors propose practical approaches that can guide companies, regardless of industry or market cap, in delivering this content in a way that is valuable to both buy‐side and sell‐side equity analysts.     

The wages of social responsibility — where are they? A critical review of ESG investing

This paper contributes both to investigating the link between the corporate social and financial performance based on environmental, social and corporate governance (ESG) ratings and to reviewing the existing empirical evidence pertaining to this relationship. The sample used includes ESG data of ASSET4, Bloomberg and KLD for the U.S. market from 1991 to 2012. The econometrical framework applies an ESG portfolio approach using the Carhart (1997) four-factor model as well as cross-sectional Fama and MacBeth (1973) regressions. Previous empirical research indicates a relationship between ESG ratings and returns. As against this, the ESG portfolios do not state a significant return difference between companies with high and low ESG ratings. Although the Fama and MacBeth (1973) regressions reveal a significant influence of several ESG variables, investors are hardly able to exploit this relationship. The magnitude and direction of the impact are substantially dependent on the rating provider, the company sample and the particular subperiod. The results suggest that investors should no longer expect abnormal returns by trading a difference portfolio of high and low rated firms with regard to ESG aspects.     

Cross‐Section of Expected Returns and Extreme Returns: The Role of Investor Attention and Risk Preferences

Previous work finds a negative and significant relation between the maximum daily return over the past one month and expected future stock returns. We determine that this effect is more pronounced for stocks that achieve their maximum daily returns toward the end of the month and stocks that are associated with capital losses show greater reversals. These results suggest the effect is related to investor attention and risk preferences.     

Issuing bonds during the Covid-19 pandemic: Was there an ESG premium?

We rely on the ESG ratings assigned by four distinct agencies (MSCI, Refinitiv, Robeco, and Sustainalytics) to study the link between ESG scores and firms’ cost of debt financing during the Covid-19 pandemic. We document the existence of a statistically and economically significant ESG premium, i.e. better rated companies access debt at a lower cost. Despite some differences across rating agencies, this result is robust to additional controls for the issuer’s credit standing as well as several bond and issuer’s characteristics. We find that this effect is mainly driven by firms domiciled in advanced economies, whereas creditworthiness considerations prevail for firms in emerging markets. Lastly, we show that the lower cost of capital for highly rated ESG firms is explained both by investors’ preference for more sustainable assets and by risk-based considerations unrelated to firms’ creditworthiness, such as exposure to climate change risks.     

A Habit-Based Explanation of the Exchange Rate Risk Premium

This paper presents a model that reproduces the uncovered interest rate parity puzzle. Investors have preferences with external habits. Countercyclical risk premia and procyclical real interest rates arise endogenously. During bad times at home, when domestic consumption is close to the habit level, the representative investor is very risk averse. When the domestic investor is more risk averse than her foreign counterpart, the exchange rate is closely tied to domestic consumption growth shocks. The domestic investor therefore expects a positive currency excess return. Because interest rates are low in bad times, expected currency excess returns increase with interest rate differentials.     

How to Integrate ESG into Investment Decision‐Making: Results of a Global Survey of Institutional Investors

The authors review the findings of their global survey of 582 institutional investors that were either practicing or planning to practice some degree of integration of environmental, social, and governance (ESG) factors into their investment decision‐making process. The investors were evenly split between asset owners and asset managers, equity and fixed income, and across the three regions of the Americas, Asia Pacific, Europe, Middle East, and Africa. The survey explored reasons for ESG investing; the barriers to such investing and investor approaches to overcoming them; and the time frames used for making investment decisions, evaluating the performance of managers, and awarding compensation. The authors report finding that the commonly perceived barriers to ESG integration—the belief that ESG integration requires sacrificing returns, that fiduciary duty prevents one from doing so, and unrealistically short‐term expectations for ESG to deliver outperformance—were not as great as commonly believed. The biggest barrier is the lack of high quality data about the performance of companies on their material ESG factors—a scarcity that the authors attribute to the lack of standards for measuring ESG performance and the lack of ESG performance data reported by companies. The results were very similar between asset owners and asset managers, equity and fixed income, and across regions. However, the investment horizons of asset owners were notably longer than those of asset managers, and the same was true of equity vs. fixed income investors. Investors in the Americas were more patient about time frames for seeing outperformance from ESG, while those in Asia Pacific were the least patient. There were also differences across regions in how to overcome the barriers to ESG integration.     

Information content of sustainability index recomposition: A synthetic portfolio approach

A firm’s inclusion on the Dow Jones Sustainability Index (DJSI) signals its leadership in Environmental, Social, and Governance (ESG). We studied the effects of DJSI inclusion using data through 2021. For additions, we found significant positive pre-announcement effects, as well as persistence of positive abnormal returns. On deletions, we also saw positive abnormal returns, although significance reduced in later years. Our analysis demonstrated a stronger information role of DJSI inclusion for non-S&P 500 firms, which suggests that the DJSI is relatively more important for firms with lower investor recognition. We used a generalised synthetic control approach to estimate our results, which responds to the parallel trends critique of stock return event studies and provides robustness to industry shocks that are so important to ESG applications. Thus, this paper represents an important extension to our understanding of the value relevance of DJSI membership.     

Initial Public Offerings and Underwriter Reputation

This paper examined the returns earned by subscribing to initial public offerings of equity (IPOs). Rock (1986) suggests that IPO returns are required by uninformed investors as compensation for the risk of trading against superior information. We show that IPOs with more informed investor capital require higher returns. The marketing underwriter's reputation reveals the expected level of “informed” activity. Prestigious underwriters are associated with lower risk offerings. With less risk there is less incentive to acquire information and fewer informed investors. Consequently, prestigious underwriters are associated with IPOs that have lower returns.     

When ESG talks: ESG tone of 10-K reports and its significance to stock markets

Since the ESG topic consistently gains on importance in the investment universe, companies provide investors with information regarding recent and future ESG activities through different reporting channels. The most recent research finds relevance of ESG-related corporate activities for formation of investors' opinion regarding companies' valuations and growth prospects. Based on a sample of more than seventeen thousand unique 10-K reports of US companies filed with SEC in period 2013 to 2019 and the word-power methodology proposed by Jegadeesh and Wu (2013), this study also shows evidence for significant relation of ESG textual tone of 10-K reports to stock market returns of filing companies around the report filing dates. Using the ESG linguistic dictionary recently proposed by Baier, Berninger, and Kiesel (2020), this study shows evidence for significant relation of social and governance-related topics disclosure to stock returns, while environmental narratives being ignored by the markets. When looking at individual words from the ESG lexicon, such words as “community”, “health”, “control” imply positive reaction of markets, while “discrimination”, “embezzlement”, and “crime” are related to negative returns. The robustness analysis based on the inverse document frequency word weightings and actual ESG performance scores confirms the significance of ESG information disclosure of 10-K reports for investors. Thus, this study sheds light on the mechanics of ESG information perception and its influence on capital markets.     

Columbia Law School Roundtable on Public Aspects of Private Equity

The mandate of the broader private equity “ecosystem” goes well beyond earning competitive returns for the limited partners and their beneficiaries. After noting that PE investing is encountering ever larger “headline” and social risks, the panelists were in complete agreement that LPs should exert greater pressure on PE sponsors to take account of and try to address negative externalities when buying and operating their portfolio companies. Bain Capital's Double Impact Fund, for example, while always looking for ways of increasing profits and reducing risk, sets out to have a positive influence on its non‐investor stakeholders, including employees. To that end, Bain develops and tracks company‐specific metrics linked to positive outcomes, and then links those metrics to management compensation. And the director of ESG programs at the International Limited Partners Association points to ILPA's programs for diversity and inclusion as a promising model.     

ESG,time horizons,risks and stock returns

Investment time horizon is an important part of significance of ESG factors. This research examines the role of ESG factors in returns and risks in short- and medium-term investment periods. It compares (a) the returns and risks of ESG portfolios between before scoring and after scoring, and (b) the returns and risks between ESG portfolios and their peers.The main results suggest that after scoring most short-term ESG portfolios have similar returns, but lower risks than before scoring. The returns of ESG portfolios are similar to those of nonESG portfolios for both short- and medium-term. There are more ESG portfolios, whose risks are different from nonESG portfolios, in the short-term investment than in the medium-term.ESG factors therefore play a greater role in risks than in returns, and in the short-term than in the medium-term. Additionally, the role of ESG factors in risks varies from industry to industry.     

Risk-adjusted option-implied moments

This paper provides a new way of converting risk-neutral moments into the corresponding physical moments, which are required for many applications. The main theoretical result is a new analytical representation of the expected payoffs of put and call options under the physical measure in terms of current option prices and a representative investor’s preferences. This representation is then used to derive analytical expressions for a variety of ex-ante physical return moments, showing explicitly how moment premiums depend on current option prices and preferences. As an empirical application of our theoretical results, we provide option-implied estimates of the representative stock market investor’s disappointment aversion using S&P 500 index option prices. We find that disappointment aversion has a procyclical pattern. It is high in times of high index levels and declines when the index falls. We confirm the view that investors with high risk aversion and disappointment aversion leave the stock market during times of turbulence and reenter it after a period of high returns.     

Corporate social responsibility as a common risk factor

This article challenges factor models widely used to explain stock returns. For European firms involved in corporate social responsibility (CSR) actions, we find a risk premium associated with extra-financial ratings priced by the market (that is, environmental, social, and governance [ESG] ratings). This premium is calculated as the excess return of low-rated firms compared to high-rated firms. To describe rated firms' returns, we propose a parsimonious two-factor model that includes both the market factor and this premium. Unlike the CAPM, three-, or five-factor models, our model is validated by the Gibbons, Ross and Shanken (1989) test. Our results lead to many managerial implications related to portfolio management, asset pricing, and corporate financial and investing decisions.     

Fear and the Fama‐French Factors

Investors’ expectations of market volatility, captured by the VIX (the Chicago Board Options Exchange's volatility index, also known as the “investor fear gauge”), affects the expected returns of US equities. Changes in the VIX drive variations in the expected returns of the factors included in the Fama and French three‐factor model augmented with a momentum factor. The market risk premium (R_m– R_f) and the value premium (HML) are especially sensitive to changes in the VIX. An increase in expected volatility is associated with flights to quality and increases in estimated required returns.