Is the environmental, social and corporate governance score the missing factor in the Fama-French five-factor model?

Abstract

Background: Companies are increasingly encouraged to focus on the creation of sustainable value. Financial research institutions evaluate companies’ performance based on pre-established indicators relating to environmental, social and governance (ESG). These scores are intended to inform decisions by equity investors, among others. However, traditional asset pricing models do not include ESG scores.

Aim: The purpose of this research is to discover whether the inclusion of ESG scores in the Fama-French five-factor model (FF5F) will improve the model’s predicting power.

Setting: Financial research institutions aim to improve the information environment in the South African capital markets. Johannesburg Stock Exchange (JSE)-listed firms are also required to produce integrated reports, emphasising responsible investment.

Method: For the largest 40 JSE-listed companies, data over the 5-year period from 2015 to 2019 were employed to compare the predicting power of the FF5F model before and after the inclusion of ESG scores.

Results: The results showed that the predictive power of the FF5F model is only marginally improved when the ESG scores are incorporated.

Conclusion: These findings indicate that equity returns are not significantly influenced by ESG scores. This research provides the basis for further endeavours on the share-price implications of ESG performance.

Contribution: This research contributes to the growing strand of literature on responsible investment and the creation of sustainable value. The research also offers a theoretical contribution by connecting literature on asset pricing with work on sustainability.