Aggregated Firm ESG Ratings and Future Stock Market Returns

Do environmental, social, and corporate governance (ESG) ratings aggregated across individual firms predict overall stock market returns? In the July 2022 version of their paper entitled “ESG and the Market Return”, Ran Chang, Liya Chu, Bohui Zhang, Guofu Zhou and Jun Tu investigate whether ESG ratings in aggregate predict overall stock market returns. Specifically, they each month:

• Combine 38 firm-level ESG subcategory ratings via equal weighting to calculate 38 market-level ESG measures.
• Apply machine learning tools to these market-level measures to suppress noise and redundancies and generate 14 market-level predictors.
• Aggregate the 14 predictors into a market-level composite ESG index, and similarly develop market-level environmental, social and governance ESG subindexes.
• Use full-sample (in-sample) regression to relate ESG index/subindexes to next-month and next-year stock market excess return (value-weighted stock market return minus U.S. Treasury bill yield).
• Use the first seven years of the sample as the initial training period and the rest of the data as an out-of-sample forecast evaluation period.

Using monthly firm ESG data from Morningstar Sustainalytics and stock market excess returns during August 2009 (ESG measurement inception) through September 2019, they find that: (more…)