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A Holistic ESG Analysis


By Kilian Smith  |  February 9, 2021

Environmental, social, and corporate governance (ESG) are three central pillars when measuring the sustainability and societal impact of investment in a company. ESG-based investing has entered the mainstream over the past decade with the assets under management (AUM) of ESG-focused ETFs increasing by over 17,700%. However, the ability of companies with higher ESG scores to outperform their lower scoring counterparts is often questioned.

Proponents of ESG believe aligning corporate behavior with positive values leads to better financial outcomes. Skeptics argue that balancing objectives of financial gain and social responsibility comes at the expense of shareholder value. Analysis of both ESG metrics that rely on company-reported information and data compiled externally indicate higher ESG scores will often lead to investment outperformance. Companies that incorporate ESG considerations into their business practices understand that ethical operation allows them to capitalize on societal trends and leads to solid market positioning, positive brand recognition, and the mitigation of risks.

Internal ESG Scoring Analysis

Sustainalytics ESG scoring measures a company’s ability to manage environmental, social, and governance issues relative to industry peers. As an assessment of a company’s overall preparedness and performance, this score gives an insightful look into the events and controversies surrounding the company and is based on internally reported data pulled from a company’s financial statements and press releases.

Sustainalytics Quintile Backtest

The companies in the S&P 500 can be grouped into quintiles based on their overall Sustainalytics ESG score and backtested over a 10-year period to determine if a higher score is correlated with outperformance. From December 31, 2010, to October 30, 2020, the geometric mean of the first quintile’s return is 1.09%, while the fifth quintile lies at 0.99%. More telling is the standard deviation of returns with the first quintile at 4.27 and the fifth quintile at 4.66. The higher returns provided by companies with the highest ESG score come at a lower risk level than the lower returns provided by companies with the lowest ESG score. This leads to a significant discrepancy in the Sharpe ratios of the two quintiles; the first quintile’s ratio lies at 0.26 while the fifth quintile lies at 0.21. In addition, the first quintile produced 18 basis points of alpha at a volatility less than that of the universe. The fifth quintile produced just one basis point of alpha at a higher volatility than the universe.

External ESG Scoring Analysis

ESG scores that don’t rely on potentially biased company reporting offer an external view of a company’s ESG performance and must be incorporated to capture the full spectrum of ESG considerations. Truvalue Labs, a FactSet Company, compiles unstructured data from thousands of external sources daily to construct ESG scores that are independent of company-reported data. Algorithms then identify ESG issues, quantify sentiment in the language, and produce the Insight score that measures a company’s longer-term ESG track record. Scores of 50 represent a neutral performance impact, scores above 50 indicate positive performance, and scores below 50 indicate negative performance.

TVL Quintile Backtest

When backtesting S&P 500 companies using the Truvalue Insight score, the first four quintiles all claim similar geometric average returns with the first three quintiles at similar levels of risk. A pattern can be observed as the Sharpe ratio hovers at 0.23. The alpha derived from these quintiles ranges from 6 to 7 basis points at beta levels of 0.94 to 0.98. Investors would be indifferent to investing in any of the three quintiles due to achieving a similar return per unit of risk at volatilities less than that of the universe.

TVL Insight Score Averages by Quintile

It’s important to note that the Insight score average for the third quintile is 60.62, close to the neutral score of 50. Beyond that quintile, the average drops to 54.58 at the fourth and 42.65 at the fifth. Based on the Truvalue Insight score, any positive ESG news for a company correlates with higher risk-adjusted returns. Whether this news is extremely positive or just above neutral is irrelevant.

Internal and External ESG Scoring Analysis

A multi-factor rank containing the Sustainalytics ESG score and the Truvalue Labs Insight score combines internal and external ESG metrics for a holistic view of a company’s ESG position. When both factors are equally weighted, the first quintile claims the highest risk-adjusted return of 0.26. Moving down the quintiles, returns decrease and standard deviations increase with the fifth quintile claiming a risk-adjusted return of just 0.19. Similarly, alpha drops by 33 basis points with the first quintile outperforming the universe by 21 basis points at a lower volatility and the fifth quintile underperforming by 12 basis points at a higher volatility.

Sustainalytics and TVL combined Quintile Backtest

The multi-factor first quintile not only outperformed its lower quintiles, but also the first quintiles of the pure Sustainalytics and Truvalue factors. This highlights the importance of combining internally-reported and externally-compiled ESG information. Based on the correlation matrix, companies falling into the first quintile of the Sustainalytics ESG factor were more likely to fall into the second or third quintile of the Truvalue factor. Internally-reported metrics can be subject to significant bias if management spins questionable operations in a positive light. The Truvalue Insight score rounds out this noise by adding insight into the market sentiment of a company’s ESG practices.

Correlation Matrix for Internal & External ESG Scores

Sustainalytics and TVL correlation matrix

Sources: FactSet, Sustainalytics, Truvalue Labs

Solely ESG Scoring or Other Factors?

One final question remains: Is outperformance the sole result of a high ESG score or are there other factors involved? Sector, revenue, and characteristic analysis of the combined ESG factor’s first and fifth quintiles can be used to answer this.

Sector Allocation by Quintile

The first quintile of the combined ESG factor is dominated by companies in the information technology (IT), utilities, and industrials sectors. The IT sector is overweight the universe by 12%, utilities by 6%, and industrials by 2%. The fifth quintile is overweight the universe in the communication services, financials, consumer discretionary, and energy sectors, all by 6%.

Out of 30 revenue sector classifications in the FactSet RBICS revenue taxonomy, the first quintile derives 12.1% of revenue from utility operations, 10.4% from industrial manufacturing, and 10.3% from electric components and manufacturing. Conversely, the fifth quintile derives 10.4% from upstream energy operations, 8.8% from insurance, and 5.9% from software and consulting. This corresponds to the contrast in sector weightings between the two quintiles.

It is no coincidence that the first quintile has a significant overweight in the IT, utilities, and industrials sectors. Tech companies consistently score high for embracing employee-oriented working cultures, utility companies for investing heavily in renewable electricity sources, and industrial companies for ensuring raw materials are ethically sourced. In complete contrast, energy companies in the fifth quintile score low for their heavy contribution to carbon emissions, financial companies for involvement in consumer scandals, and communication services companies for poor employee satisfaction.

Ratio Analysis for Combined ESG Score Quintiles


Quintile 1

Quintile 5


Market Value (Mil. $)




EPS Growth Rate (%)




Sales Growth Rate (%)




Return on Equity (%)




Return on Invested Capital (%)




Net Margin Ratio (%)




Cash Flow Margin (%)




Price-to-Earnings Ratio




Price-to-Sales Ratio




Price-to-Book Ratio




Price-to-Cash Flow Ratio




Debt-to-Assets Ratio (%)




Debt-to-Equity Ratio (%)




Sources: FactSet, Sustainalytics, Truvalue Labs

Fundamentally, both the first and fifth quintiles resemble the S&P 500 universe. The variances are a testament to sector over- and underweights rather than any characteristic benefit or drag. The first quintile’s marginally higher return on equity and lower EPS growth rate as compared to the universe are attributable to consistent profits in the utilities and industrials sectors. The quintile’s higher price to earnings ratio is attributable to the often stretched valuations of the IT sector.

The fifth quintile operated with negative price-to-earnings and price-to-book ratios. It also retained a return on equity 27% lower than the universe and an EPS growth rate 48% higher than the universe. This is attributable to the fluctuating profitability of the energy sector.


Over the past decade, investing in a portfolio of first quintile securities would have resulted in a cumulative return of 272%. The second highest return would have been provided by the second quintile at 233% and the third highest by the fifth quintile at 198%. The cumulative return of the S&P 500 index over this period was 219%. Investing in any quintile besides the first and second would have resulted in a return less than that of the index itself.

Cumulative Returns by Quintile

The IT sector contributed 51% to the S&P 500’s 219% total return over the past decade while the energy sector detracted from that return by 24%. The overweighting of each sector in the back test was the primary contributor to the first quintile’s outperformance and the fifth quintile’s underperformance.

Contribution to S&P 500 Return by Sector

Constituents of the IT sector have made a conscious effort to adopt quality ESG systems that they employ to create societal value through their products and services. This adherence to ethical operation has benefited them in the form of increased brand awareness, consumer loyalty, and risk mitigation. The integration of ESG considerations into business practices ultimately leads to superior investment performance, demonstrating that companies can do well while doing good.

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Kilian Smith

Analytics Product Specialist