Chasing the ESG factor

We analytically compare two dominant methodologies for the construction of an ESG factor: the time series (ratings used to sort stocks) and cross-sectional (ratings used to weight stocks) approaches. Differences in ESG rating and exposure to other firm characteristics imply an ex ante expected return spread between the two factors. We construct a cross-sectional factor (i) featuring a targeted rating, thus allowing comparability with other factors, (ii) neutralizing exposure to other firm characteristics, and (iii) not harming diversification through stock screening. Using ratings from several data vendors, we document strong variations of the factor alpha in the time series and across vendors. The conditional alpha is negatively related to the level of media attention for ESG and positively related to variations in media attention.(c) 2022 Elsevier B.V. All rights reserved.

Automated summary

This article analytically compares two dominant methodologies for constructing an ESG factor: the time series and cross-sectional approaches. Differences in ESG rating and exposure to other firm characteristics lead to an expected return spread between the two factors. A cross-sectional factor is constructed in this study, which features a targeted rating, neutralizes exposure to other firm characteristics, and does not harm diversification through stock screening. The research finds strong variations in the factor alpha across time series and different data vendors, and it is negatively related to media attention for ESG and positively related to variations in media attention.