Volatility and returns of ESG indices: evidence from Japan

In this study, we compare the volatility characteristics and return performance of MSCI Japan ESG Select Leaders Index (SLI) and, its parent index, MSCI Japan Investable Market Index (IMI). SLI is an environment, social and governance (ESG) index, which integrates firms’ ESG performance into the stock selection, and IMI is a conventional market capitalization-weighted index. We utilize the stochastic volatility (SV) model that integrates the Fama–French five— (FF5) factor model (Fama and French, J Fin Econ 116:1–22, 2015). The daily data of each index from January 5, 2015 to August 31, 2023 are used in the analysis. The results show that the asymmetry effect of volatility, which is the market anomaly of increased volatility immediately after price declines, in SLI is smaller than that of IMI, and no difference in the excess return to the market is shown between SLI and IMI. We also found that the COVID-19 pandemic increased the volatility of SLI and IMI, however the volatility of SLI expanded at a slower pace during the pandemic. Our empirical results indicate that considering corporate ESG initiatives when constructing indices or portfolios may make them more defensive in bearish market conditions without reducing the excess return.