Introduction
Momentum in stocks is not only a key strategy in the many portfolios of practitioners, but it is also an attractive research topic for academics. The original idea behind momentum, is that past winner tend to perform well in the near future, and vice versa, past loser tend to underperform (Jegadeesh and Titman, 2001). Later, the momentum anomaly was found practically everywhere, Moskowitz, Ooi, and Pedersen (2012) identified momentum in an equity index, currency, commodity, and bond futures. Hartley (2020) identified momentum anomaly in global yield curves. Moreover, the momentum factor is also presented in the equity factors, as concluded by Arnott, Clements, Kalesnik and Linnainmaa (2019).
While momentum anomaly is a staple in the financial literature, the theory behind socially responsible investing or ESG investing, and mainly ESG scores is emerging. E score stands for environmental, S for social and G for governance qualities of firms. Aim of the score is to measure quality or responsibility of the firm in each of the categories mentioned above. We have also reviewed literature related to the ESG investing, and have concluded that ESG scores could be successfully used in practice, utilized in negative screening, level, or momentum strategies. It is no surprise that researchers looked for momentum in ESG scores.
What will happen if we mix ESG scoring with price momentum? Can we improve simple ESG investing strategy?
Quantpedia’s newest research paper written by Matus Padysak answers these questions. Let’s start our analysis with the following analogy – the relationship between price equity momentum and ESG scores can be compared to a robber in a jewellery store with a knapsack of limited capacity. The ESG scores and momentum anomaly can be related to the famous optimization Knapsack problem. One of the most straightforward explanations of the Knapsack problem is a robber that has limited capacity in the backpack, and naturally, wants to return from the store with a maximal loot. Therefore, the weight of the loot is limited, and robber wants to maximize his profit by choosing the most valuable combination of items that would fit into his knapsack.
The Knapsack problem applied to the equity momentum and ESG scores can form two different scenarios.
Firstly, it is possible to make classical momentum more “sustainable“ or ESG friendly. In this case, the aim is to pick stocks with the highest momentum, but at the same time, maximize the ESG score of the portfolio. In other words, the momentum represents the weight, the higher the momentum, lower the weight. The limited capacity of the knapsack ensures that only stocks with high momentum (low weight) would be included in a portfolio. The ESG score of each stock represents the value. Therefore, picking stocks with the lowest “weight“ and maximizing the “value“ creates a more ESG friendly momentum strategy.
Secondly, the situation can be reversed, and ESG can represent the “weight“ of the stock – higher the ESG, lower the weight. In this case, momentum represents the „value“ of the stock. In practice, such an approach chooses portfolio with as highest ESG as possible while maximizing the momentum of the stocks.
The first approach can be used to make the portfolio more attractive in terms of the ESG scores. The average ESG score of stocks in a portfolio can be significantly improved, with only a slight reduction in the performance. The second approach leads to a portfolio that can be without a doubt called as socially responsible according to the ESG scores. Additionally, this approach largely improves the returns of ESG strategies compared to, for example, the ESG level or momentum strategies as shown by Dorfleitner, Utz, and Wimmer (2013) and Nagy, Kassam and Lee (2016). Moreover, compared to the traditional momentum in stocks, both the volatility and maximal drawdowns are substantially improved, leading to a better risk-adjusted return compared to the momentum alone.
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https://quantpedia.com/esg-scores-and-price-momentum-are-more-than-compatible/
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