ESG, Fundamentals, and Stock Returns

For decades, modern portfolio theory's function has been delivery of risk-adjusted wealth maximization. For a shorter and more recent period, ESG's (environmental, social, and governance) function has been adherence to social preferences. This article addresses the empirical impact of ESG scores on stock return. It does so with a formal statistical decision tree (classification and regression trees, or CART) to understand the nonlinear and interactive role of ESG scores in an otherwise wealth-maximizing objective. Empirical evidence on stock return from the years 2013-2021 demonstrates that fundamentals (earnings phenomena) consistently dominate relative stock performance. ESG as a stand-alone input plays little or no role; however, in the presence of fundamental drivers, ESG interacts as a subordinate influence on return in some years. This leads to a potential paradigm for joint integration of quantitative fundamentals with ESG scores to achieve higher returns.