Interpreting ESG Portfolio Alpha and Momentum
Summary
The question describes annual sorting of stocks into portfolios by ESG score, holding each portfolio for seven years, rebalancing annually, and regressing monthly returns on the Fama-French five factors plus momentum. The reported pattern is negative alpha with positive momentum for high ESG portfolios and positive alpha with negative momentum for low ESG portfolios. The author asks whether past underperformance and resulting undervaluation could explain later positive alpha in low ESG stocks.
The response emphasizes aligning the timing of ESG classifications with the return data and choosing factors that control for plausible return drivers. It suggests that factor selection is central to interpreting alpha: a significant intercept is conditional on the variables included in the regression. The exchange does not establish a causal explanation for either portfolio pattern, provide supporting empirical tests, or resolve whether the proposed undervaluation account fits the data. Its guidance is methodological and brief, so the observed associations should not be treated as proof of a mechanism.
Key ideas
- Alpha depends on which return factors are included in the regression.
- ESG classifications and return observations should use a consistent time basis.
- The reported alpha and momentum patterns do not by themselves establish why returns differ.
- Testing an undervaluation explanation would require additional evidence beyond the described regressions.
Tags
Full text
# Interpretation of significant positive Alpha and negative Momentum # Interpretation of significant positive Alpha and negative Momentum I have observed that my portfolios constructed according to positive ESG criteria consistently show negative alphas and positive momentum, while the portfolios with negative ESG criteria show positive alphas and negative momentum. I'm not sure how to interpret this correctly in economic terms: Would be this interpretation correct?: One reason could be that the portfolio with negative ESG criteria had below average returns in the past and was therefore under pressure, which led to an undervaluation of the stocks, which later reversed and led to the positive alpha. Portfolio construction: I used the FF5 plus momentum. I first sorted my stocks by their annual ESG scores. Then I created a portfolio based on the ESG quantiles of the companies and let it run for 7 years. Each year I rebalanced the portfolios based on the ESG scores and quantiles. I then regressed the monthly returns on the FF factors. I noticed that the portfolios with higher ESG scores in particular have a negative alpha and positive momentum, while the portfolios with more negative ESG scores have a positive alpha and negative momentum (both always significant). Thanks in advance Greetings ## Answer by KaiSqDist (score 0) https://quant.stackexchange.com/a/79584 Usually the frequencies should be the same. If it were up to me, I would keep the ESG criteria constant per the year during the regression. Your independent variables are up to you, but there is a lot of research on factors that could explain the returns. For example, you could use the Fama-French factors, style, momentum, even economic variables could be useful to control for factors that result in the returns. I would say this is the most important part of the return explanation.
Shown in full with attribution under the source's licence. Licence: CC BY-SA 4.0 (Stack Exchange)
This summary was written by Stratmill's research agent from the original; it is not a copy of the source.