Do we need to put a Q in ESG?

Conviction Equities Boutique
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Key takeaways

  • Opinion is divided on whether ESG provides a set of new independent factors constituting a distinctive source of returns. For many, this question rests on the overlap between ESG and the investment style factor of quality.
  • Complexities play a key role in this discussion, from multiple approaches toward the definition of quality, to the differences of ESG strategies across emerging and developed markets, to walking a tightrope between the need for standardized ESG methodologies and their potential to eliminate nuances.
  • Our Vontobel Conviction Equities team regularly integrates “ESG/sustainability” analysis with the screening of quality companies, mostly through the lens of profitability. This experience shows us that ESG is undeniably correlated to quality yet, at least when quality is defined in a narrow sense , but stands for more than that.


Is ESG simply a different label for quality? Or could quality stand for a less controversial and politically sensitive description of highly sustainable companies? The question whether ESG characteristics of listed companies constitute a new independent factor and thus a distinctive source of returns from academically backed-up systematic factors,1 has been increasingly discussed in the investment community over the last few years. To keep this debate simple, it’s possible to classify the broad range of opinions on this topic into two main categories:

Opposing ends of the debate

One view is that ESG scores or ratings may not provide any truly new information, since they’re already included in well-documented investment style factors like quality, momentum, size, and volatility. Studies supporting this view generally don’t conclude to any statistically convincing relationship between an idiosyncratic ESG residual (not explained by correlations with traditional factors) and portfolios’ active returns (see box 1 for a survey of recent academic literature).

At the other end of the spectrum, some studies attempt to highlight the existence of an ESG “alpha”, not resulting from traditional factors’ exposures. While they don’t reject a certain level of overlap between ESG ratings and some factors, and especially between governance ratings and various quality sub-factors (e.g. low leverage and low earnings variability), such studies also point to a small, yet statistically significant and stable, premium from ESG characteristics, independent of traditional factors.

Where ESG and quality overlap

The empirical jury is apparently still out. However, investment practitioners with a history of integrating ESG sustainability criteria into stock selection processes focusing on quality companies across different markets could cast a different light on where ESG and quality overlap.

It’s first worth highlighting that, unlike the factors of value or size, there is no simple, consensual, and decisive definition of quality. Academics and portfolio managers often diverge between the dimensions (including safety, variability, and profitability) and the precise set of indicators used to screen quality companies. Therefore, subject to the choice of the underlying quality metrics, the space left to ESG factors to provide “extra information” and yield an autonomous premium could vary.

In our case, as we tend to favor a definition of quality focusing on profitability – a quality sub-factor that, on average, has the least correlation to ESG ratings – we often find the value generated by our ESG research extends beyond the preliminary screening and subsequent financial analysis of quality companies. In 2020, our mtx emerging markets team analyzed the relationship between ESG and returns on invested capital (ROIC) scores and the impact of ESG in high ROIC companies. This analysis concluded that ESG acts as a proxy for quality, adding a minor active return, a bit more sizeable for high ROIC companies. A portfolio manager focusing more on safety (low level of leverage and high level of cash) would have probably reached a different conclusion.

Emerging versus developed markets

Beyond their divergences, most empirical studies agree that correlation levels between ESG characteristics and quality features are not the same across different markets. They’re usually much lower or nonexistent in emerging markets.

The practical observations we’ve made tend to support this. Applied to emerging markets, our integrated ESG approach has proved a persistent source of value add, in terms of risk reduction and/or return enhancement, relative to a traditional quality screening (even centered on profitability). By contrast, applying our strategies to developed markets may have led to a lower influence from ESG analysis on average. But exceptions are always possible, such as when technological advances in “clean production” for a leading Swiss manufacturer in a “high emitting part of ndustry” helped secure its industry positioning and higher equity valuation.

In developed markets, a more effective way to reveal discriminate sources of “sustainable growth” is to extend sustainability analysis to the impact dimension of business models. This includes measuring a business’ capacity to answer – better than others – the need of the global economic transition involved by major environmental and social challenges.

The important role of nuance

Where the academic literature on this topic aligns is in its extensive reliance on ESG rating sources with the highest coverage and longest history. How useful such sources may be in ensuring a basic coverage of a large universe, as well as the flaws and occasional inconsistencies of this data, has been widely documented. This is particularly true for ratings agencies’ need to answer standardized methodologies, which may lead to a lack of nuances – and sometimes relevance – between industries, geographic markets, capitalization size, etc. This is where a more granular, nimble, and focused approach – which concentrates analysis on the dimensions and criteria really material to each of the sub-sectors and geographic markets – could add significant value relative to the systematic use of primary data.

In conclusion, our practical experience of integrating various level of “ESG/sustainability” analysis with our screening of quality companies confirms that ESG analysis is an additional source of information that is generally rewarded positively. However, this source may vary depending on how we define quality, our investment universe, and the materiality of the ESG dimension we are scrutinizing for various industries and markets. ESG is undeniably correlated with quality, but we reasonably believe it stands for more than that, at least when quality is defined in a relatively narrow sense.

A brief survey of the recent literature about ESG as an independent factor

A large number of studies have established a high correlation between usual ESG ratings and some well-established investment style factors, such as quality and volatility.2 For instance, using holdings of 1312 US active equity mutual funds with USD 3.9 trillion in AUM, Madhavan, Sobczyk, and Ang (2021)3 concluded that environmental scores were particularly sensitive to factor exposures, with more than 75 percent of the changes in fund-level environmental scores explained by style factors. The same study isolated an “idiosyncratic” ESG score, not explained by the factors most correlated to the “ESG factor”. No statistically convincing relationship between this idiosyncratic ESG score and the funds’ active returns was established, suggesting ESG scores alone weren’t providing additional information beyond that already embedded in the style factors.

Supporting ESG as a partially independent factor, Chen and Deleon (2020)4 found that portfolios built with a combination of ESG and quality factors display stronger return characteristics than those built with each of the two factors alone, suggesting some independent information between them. Bennani, Guedenal, Lepetit, Mortier and Sekine (2018)5 found that ESG may be an independent risk factor in Europe but not in North America, where it proved redundant to other factors. A more granular analysis by, Behringer, Bush, Dahlhaus, and Sidorovitch (2023)6 confirmed correlations between ESG and quality scores were low in Europe, North America, and emerging markets. The correlations were higher between ESG and the safety sub-factor (low leverage and low earnings variability) and lower with the profitability one. Unsurprisingly, ESG scores related to governance displayed the highest correlation with overall quality, and those related to social issues the lowest. The correlation between ESG and quality factors proved higher after the COVID outbreak. Regressing portfolios returns against a set of multi-factors (quality, momentum, size, value, and ESG) the authors concluded the ESG factor yielded its own, albeit smaller, relatively stable premium, independent of other factors.






1. As a useful reminder, factors are set of characteristics that are rewarded for bearing well-identified sources of risks, structural impediments, or behavioral biases. They are systematic in the sense that they will apply to all companies sharing the characteristics defining a factor. Companies could always generate an “extra” return (positive or negative) that cannot be explained by factors. This idiosyncratic performance will stand as the “true” alpha at the level of a single stock or a whole portfolio.
2. “Integrating ESG into factor portfolios”, Melas D., 2016, MSCI Research – “Assessing Risk through Environmental, Social and Governance exposures”, Dunn J., Fitzgibbons S., Pomorski L., 2018, Journal of Investment Management.
3. Madhavan A., Sobczyk A. and Ang A. “Toward ESG Alpha: analyzing ESG Exposures through a Factor Lens” (Financial Analysts Journal, 2021).
4. Chen Y. and Deleon A. (2020) “Financial Quality metrics and ESG factor interactions in Equity markets”, The journal of Impact & ESG investing
5. “The alpha and beta of ESG investing”, Bennani L., Guedenal L.G., Lepetit F., Mortier L. Ly. V., Sekine T., Amundi, 2018.
6. “ESG and Quality are not the same”, Behringer A.-K., Bush R., Dahlhaus J., Sidorovitch I., The Journal of ESG and Impact Investing, Spring 2023.


Important Information: Environmental, social and governance (“ESG”) investing and criteria employed may be subjective in nature. The considerations assessed as part of ESG processes may vary across types of investments and issuers and not every factor may be identified or considered for all investments. Information used to evaluate ESG components may vary across providers and issuers as ESG is not a uniformly defined characteristic. ESG investing may forego market opportunities available to strategies which do not utilize such criteria. Unless otherwise stated within the strategy's investment objective, information herein does not imply that the Vontobel strategy has an ESG-aligned investment objective, but rather describes how ESG criteria and factors are considered as part of the overall investment process.

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