Analysis on the applicability of ESG as a factor in factor models

Abstract

This essay investigates in whether ESG can be constructed as an additional factor into three factor models, CAPM, Fama-French 3 Factor Model, and Fama-French 5 Factor Model, to predict the market return and the industry return of 11 respective stock groups. The models run against industry return recognize the heterogeneity among the stocks and aim at identifying industries that are appropriate to be analysed with factor models. In addition, the data was transformed into datasets with two different time intervals, half year and one year, for experiments, and the market return and the return of each stock group will be run against the constructed factors, leading to a total of 144 models. The two-data interval modelling takes into the account the essence of the implementation of ESG measures by companies, which practically has a lagging effect and may require longer-term observation to view the result. The result shows that there is no sufficient evidence that ESG factor can be used to predict the market return, namely, the return of Hang Seng Index. Nevertheless, ESG factor is able to predict the return of some industries, and the number of industries having applicable ESG-added factor models increases when the data interval is increased. These industries include consumer goods manufacturing, energy, industrial goods, property and construction, and services, under the data interval of one year. However, there is only industry, consumer goods manufacturing, having applicable models under the data interval of half year.