Is ESG a systematic risk factor for US equity mutual funds?

What is it about?

We have shown for the first time that ESG is compensated systematically in the US equity mutual fund market. We explain the nature of return differential between responsible investing (RI) and conventional investing (CI) within the well-known risk-return paradigm. From the viewpoint of ex-ante equity risk premium (ERP), the five factor model of Fama and French (2015) applies to returns on 1,425 US open-end equity funds for the period from April 2009 to December 2016. Empirical findings show that i) US open-end equity funds tend to hedge the ESG-related systematic risk, ii) the exposure to ESG-related systematic risk is significantly priced in the market, and iii) equity funds have become more capable to factor CSP into their investment decisions.

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Photo by Taylor on Unsplash

Photo by Taylor on Unsplash

Why is it important?

We explain the nature of return differential within the well-known risk-return paradigm. To do so, we focus on the ex-ante return differential rather than the ex post return differential. Since the ex-post outperformance of RI depends on whether a financial loss is triggered by ESG-related events, the evidence on historical returns is naturally mixed. In contrast, RI can be viewed as a hybrid of CI and the downside protection against the ESG-related systematic risk to which CI is exposed. Thus, the ex-ante return differential between well-diversified RI and well-diversified CI depends on how large is the exposure to ESG-related systematic risk. With this ex-ante view, the total equity risk premium (hereafter, ERP) on CI can be decomposed into two components: ERP on RI and the price of downside protection by RI.

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