Interim Report by- AYUSH KUMAR

REG NO-2022MMBA07ASB278
ESG performance, herding behaviour and stock market returns: evidence from Europe

ABSTRACT
This paper tests how fInancial performance indicators and combined ESG score for large-cap stocks
impact on stock return. In particular, THIS paper examine how market capitalization, price to book
value, Sharpe ratio and ESG score of large-cap firms in Europe are related to their stock performance.
This paper consider a panel data consisting of six European countries—Portugal, Italy, Greece, Spain,
France and Germany— for the period 2010–2020. , this report shows no evidence that ESG motivates
herding for selected sample (this is not the case for Greece and France), while this report evidence of
ESG herding behaviour during the Covid-19 outbreak in Portugal, Italy and Greece

INTRODUCTION
The role of a sustainable (low-environmental impact) company, in recent years, has become crucial in
financial markets, especially in Europe. Therefore, a lot of firms adopt sustainable approaches that
combine the evaluation and application of Environmental, Social, and Governance (ESG) factors. The
selection and construction of an investment portfolio that is based on sustainable strategies might
capture better long-term returns and benefit society by affecting the social conduct of companies. In
recent decades, climate changes and social inequality have forced market regulators and policymakers
to devote their actions to more sustainable practices based on ESG pillars. Those actions aim to
promote the transition to renewable energy and to pivot towards more proactive climate and
sustainability-focused positions .investors ask companies that focus on sustainability, as represented
by the increase of recourses to green bonds and social impact assets. PricewaterhouseCoopers
(pwc.com) estimates assets under management (AUM) across ESG funds in Europe to be between €
2.6 trillion and € 3.6 trillion by 2025. Deloitte (deloitte.com) reports that by 2025, ESG assets under
management will reach close to $35 trillion. As Morningstar Research (Global Sustainable Fund
Flows Q2 2022) has noticed, Europe remains the most developed and diverse ESG market with 82%
in the 2nd quarter of 2022, followed by the U.S. (12%). As a result, 245 new ESG products entered
the global market in line with the 1st quarter of 2022, numbered 242. present study is motivated by
exploring the current interesting shift of investors and fund managers into ESG strategies by adding to
the equation fnancial factors, like stock performance, frm size (Mcap), frm value (P/BV) and risk
value (Sharpe ratio). We chose the above financial factor, as investors and fund managers usually
involve them in their investment decisions. this analysis contributes to the academic debate on
financial and ESG issues by extending it to Europe, the biggest market for sustainable funds and
addresses a relevant gap in the existing research. The second motive for this study, is to focus on ESG
herding in Europe. According to this report, this is the first research containing ESG issues and
herding behaviour in several European countries. ESG herding is the tendency to imitate the
observed actions of others, instead of following own beliefs concerning ESG investment decisions.
The current increased focus of investors and fund managers on incorporating ESG practices in their
asset selection, allocation and diversification of their investment portfolio is called socially
responsible investing (SRI) and might capture long-term better or be used as a safe—haven strategy
leading companies to follow better corporate governance practices and, in this way, beneft overall the
society. Moreover, the increased demand for ESG assets possibly could leads to herd behaviour and
price anomalies. To study this timely phenomenon is critical not only to herding literature but also to
all market participants. The current study covers two aspects: the impact of financial performance
indicators and ESG score on stock return and the infuence of ESG score on herding behaviour. More
precisely, this research is focused on the question of how market capitalization, price to book value,
Sharpe ratio and ESG score of large-cap frms in six European countries are related to their stock
returns. In addition, the asymmetric behaviour of return dispersions concerning ESG performance is
evaluated.

literature review

Starting from the main objective of the conducted study, four factors have been defined: Market
capitalization (Mcap), Price to Book Value (P/BV), Sharpe ratio (Sharpe) and Environmental
Social Governance (ESG) factors. Those determinants are very crucial not only for the financial
performance of the company but also for investors and fund managers in the process of stock picking
and portfolio construction.. The knowledge of Mcap is critical to building a portfolio with assets of
different size mixes. In their study, (2016), found that companies in sensitive industries (SI) produce
better ESG performance considering BRICS countries, even when the size (Mcap) of the company
and the country are controlled. (2021) reinforces the idea that ESG scores have the potential to
increase portfolio performance in US small cap stocks. In their study, Engelhardt et al. (2021),
examines the relationship between ESG ratings and stock performance during the COVID-19 crisis
and come up with a positive and statistically significant coefficient on market capitalization (size),
ROE, market to book ratio, historical volatility and momentum. In addition, they deduce that high
ESG-rated European firms relate to lower stock volatility and higher abnormal returns. The
price to book value ratio (also called market to book ratio) is a metric used mostly in value investing
to evaluate the present market value of an asset relative to its book value. Market-based measures,
such as P/BV mirror the market’s consensus of both contingent and present profitability and capture
the indefinable value in the stock market above the book value of the company (Hassel et al. 2013).
Book value adjusted for inflation has a stronger relationship with asset values. (2006) point out in
their study. Investors and asset managers should give more attention to P/BV than earnings in periods
with high inflation.. The meaning of diversification is vital when constructing an investment
portfolio.. Sharpe ratio (Sharpe 1963) is a method of spreading the risk without inducing the return
negative and constitutes one of the most used risk and return metrics in portfolio management. Sharpe
ratio can elucidate if the return of an asset is a reason for “smart investment decisions” or if the
investor has taken a high risk. In other words, Sharpe ratio is the average return earned over the risk-
free rate after adjusting for its risk. (2016) analyze if ESG score impacts the volatility of U.S. stocks.
They found Sharpe ratio for ESG companies is greater than their peers in the same sector and reported
that firms with higher ESG scores create higher returns. Moreover, they deduced that investors could
have earned a higher-than average return for each unit of risk taken if they had invested in stocks with
a high ESG score.. (2018) argued that the companies with a lower level of risk and good ESG
practices are inclined to have more dedicated employees, a lower probability of lawsuits, more loyal
customers, and as a result higher company valuation level. (2022) analysed the consistency of Sharpe
ratio estimator and concluded that the Sharpe risk indicator is consequent in minimum and mean–
variance portfolios. In the past several years, ESG has growing attention in the academic, business
and political realms. ESG is the use of Environmental Social and Governance (ESG) non-fnancial
factors in evaluating the progress of companies on sustainability practices.. A better understanding of
ESG importance in our changing world will benefit investors, companies and the society overall. In
their study,. (2015) concluded that firms that develop sustainable strategies yield greater financial
returns. In addition, investors taking sustainability into account can deliver improved investment
performance. (2016) argue that MSCI’s ESG stocks portfolio outperformed the MSCI World index
over the sample period of 2007–2015.. Velte (2017) presents evidence that ESG has a positive effect
on return on assets (ROA), but no effect on firm value (measured by Tobin’s Q). ESG increases the
financial performance of German companies in short term, but not in the long run, as Velte (2017)
identified . (2020) study show that there is a positive relationship between environmental and social
performance among Asian companies for the period between 2005 and 2017.. In another study,.
(2015) examines the impact of environmental social and governance actions on firm value and found
that strong ESG practices elevate firm value and ESG concerns diminish it. In addition, when ESG is
isolated, then the firm value is decreased.. Another study conducted by. (2017) on large-cap stocks in
Australia showed that portfolios based on ESG ratings have no significant difference in risk-adjusted
returns. There is no relationship between climate change policies and emission reductions with the
fnancial performance of largecap U.S. companies as identified by Petitjean (2019). Moreover, La
Torre et  al. (2020) investigate how ESG score affects the stock performance of companies that
constitute the Eurostoxx50 index, over the 2010–2018 period and concluded that the performance
does not seem to be influenced by the company’s actions in terms of ESG commitments. Based on the
review of the literature, the current article examines the following hypothesis for six European
countries. H1 Market capitalization, Price to book value, Sharpe ratio and ESG performance affect
stock returns. The review of the literature leads to the second contribution of this study, the
investigation of herding behaviour on ESG stocks. The current advanced demand for ESG assets
might lead investors and fund managers to herd behaviour (Przychodzen et al. 2016; Benz et al. 2020;
Rubbaniy et al. 2021). Most of the time inexperienced investors follow the investment behaviour of
others who are believed to be “market experts”. At the same time, the growing signifcance of ESG
investment practices drives many investors to take “personal action” by adding constantly ESG assets
to their portfolios without taking care of the diversifcation. This non-rational behaviour creates
herding that can cause massive infows into particular asset classes like ESG by creating a market
bubble. In addition, lower or non-exposure to ESG investing during days of market stress (D’Hondt
et al. 2022) might mean that investors don’t prefer ESG assets on crisis periods. This behaviour could
create ESG herding leading to a market crash. In her study, Blondel (2022) found that medium-risk
profle investors herd for traditional investments more than ESG investments. Regarding ESG
investments, passive investors seem to herd more than active investors as Blondel (2022) concluded.
Finally, in their study, Youssef et al. (2022) examined the impact of COVID-19 crisis on herding
behaviour in the cryptocurrency market and noticed the existence of herding during the COVID-19
crisis. (1990) evidenced that when the performance of fund managers is assessed relative to others, the
fund managers who lack confidence are apprehensive of underperforming and thus are more intense
to mimic the trading behaviour of other fund managers, who are more experienced and qualified.
Walter et al. (2006) detects spurious herding (when investment decisions are alike but based on an
independent analysis by professionals) of mutual fund managers in Germany as an aftereffect of
changes in benchmark index composition. Moreover, Choi et al. (2009) document strong institutional
herding in U.S. companies. Przychodzen et al. (2016) investigate the behaviour, motives and
characteristics of mutual fund managers who incorporate ESG strategies into their investment
decisions by providing evidence of herding behaviour. In their study, Benz et al. (2020) analyze
institutional ownership data and conclude that investors, portfolio advisors and hedge funds follow
herding behaviour when decarbonizing their portfolios. Furthermore, they concluded that Institutional
investors (mutual funds and hedge funds) follow ESG herding due to anxiety to accomplish the
market return consensus by imitating their peer’s investment strategies. Similarly, Pension funds and
Insurance companies are committed to societal norms and values driving them to invest constantly in
ESG assets. Moreover, by using data of the MSCI U.S.A. ESG leader index, Rubbaniy et al. (2021)
identify herding behaviour during both bear and bull market conditions over the period 2007–2020.
On the other hand, Babalos and Stavroyiannis (2015) confrm an anti-herding behaviour in metal
commodities futures before the global financial crisis. Rompotis (2018) examined a sample of 66
large-cap and 34 small-cap exchange-traded funds (ETFs) and found no herding effect over the period
2012–2016. (2019) concluded that small firms with a high level of herding underperform those small
firms that experience a low level of herding. More recently,. (2021) find no evidence of herding in
cryptocurrencies during Covid-19, but report that herding is contingent upon the up and down-market
conditions. Finally, using a dataset of 10, 456 unique global ESG funds from 2012 to 2018,. (2021)
found that ESG funds exhibit an anti-herding behaviour. Based on the previous review, some studies
show a positive relationship between herding and ESG performance, while others show no herding
effect. By focusing on ESG herding our study contributes to the academic discussion on herd
behaviour by examining H2 Companies adopting ESG practices do not necessarily induce herding
behaviour.

Methodology and data description

This research use Refnitiv’s database for ESG scores as it takes into consideration combined scores
(Refnitiv 2020). DataStream Refnitiv Eikon is chosen for retrieving yearly data since it provides one
of the most inclusive databases, covering over 80% of the global market cap across more than 450
diferent ESG measures (Breitz and Partapuoli, 2020). These measures are divided into three main
categories and ten subcategories. The categories are Environment (E), Social (S) and Governance (G).
ESG scores were calculate.
Dependent variable Measurement
Rit (Stock return)- The total return is the amount of value an investor earns from a security over a
specifc period. It is expressed as a percentage of the amount invested.
Independent variables
Mcap -(Size)Market cap (market capitalization) is the total value of all a company’s shares
of stock. It is calculated by multiplying the price of a stock by its total
number of outstanding shares.
P/BV (Valuation)- Price to Book Value is calculated by dividing the company’s latest closing
Price by its Book Value per share.
Sharpe ratio (Risk)- The Sharpe ratio is the average return earned over the risk-free rate after
adjusting for its risk.
ESGt (Environmental Social Governance) score-ESG Combined Score is an overall company score
based on the reported information in the environmental,

Conclusions
Previous studies report a positive effect of ESG score and the financial performance of a firm,
measured both by accounting and market-based indicators. A small number of studies show a negative
relation, mainly for a single market. Furthermore, many studies report a non-significant relation. The
current study aims to analyze a firm’s stock returns as a function of indicators, such as a firm’s size
(Mcap), valuation (P/BV) ratio, risk (Sharpe) ratio and ESG score. To achieve this, we focus on six
European countries. Our study contributes to relevant literature by providing evidence of the
integration of market capitalization, price to book value, Sharpe ratio, stock returns and ESG
performance of large-cap firms in Europe. Furthermore, it appears that higher infows in certain asset
classes are often the driving force behind herding behaviour. Current investment strategies constantly
focus on sustainability and, as a result, ESG investment is a strong candidate for the investigation of
herd behaviour. This motivates us to analyze whether ESG issues lead to herd behaviour. The
enlightenment of ESG herding improves not only investment decision-making, but also the process of
constructing a well-diversified and optimized portfolio. However, despite the recent shift in the
investment choice of global investors towards ESG stocks and the growing focus of academics on
companies that adopt ESG practices, the existing literature has rarely highlighted the issue of herd
investing in ESG stocks (Rubbaniy et al. 2021). The results of this paper have several practical
implications for the financial markets and their participants. First of all, the fndings for fve out of six
European countries (Portugal, Greece, Spain, France and Germany) show that investors do not
sacrifice their returns by investing in firms with high ESG scores, which means that sustainability
concerns are not as high on the investor’s agenda. However, the benefit of not investing in highly ESG
scoring firms might lead investors to select smaller size companies with a higher price to book value
and higher Sharpe ratio as it is more likely to create higher returns. Our results offer new insights into
investors and finance professionals by helping them to detect how financial (Mcap, P/BV, Sharpe
ratio) and non-financial (ESG) factors might affect portfolio construction and performance. In
particular, inexperienced investors and fund managers should be informed in more depth about ESG
issues as it seems to play an important role within the sustainable investment frame. Secondly, the
findings are robust to Europe as a whole, using the Euronext100 large-cap index. Investors in Europe
as whole sacrifice stock returns by buying companies that implement good ESG practices. This
valuable and apropos result possibly means that European investors overall are socially responsible
and implement portfolio diversification or long-run strategies. In addition, this novelty finding
confirms the advancing strength of Europe as the biggest market for sustainable funds globally.
Thirdly, our results indicate that there is an interaction between ESG performance and herding in
Greece and France. In addition, ESG investors in Portugal, Italy and Greece are involved in herd
behaviour during the Covid19 crisis, which may result in market inefficiency and less diversified
portfolios. ESG investors in Spain, France and Germany do not mimic the trading choices of others
during the same period. This anti-herding behaviour probably indicates that highly ESG scoring
stocks conduce to market efficiency by lowering the probability of the financial bubble formation.
Lastly, the advantageous findings of this paper will help Asset Management Companies to understand
the importance of herding behaviour on ESG performance and take rational and proftable decisions.
The results of this study offer useful policy implications in understanding the financial behaviour
drivers of market participants. Policymakers and regulators must ensure that all market participants
should have free access to all relevant information, otherwise, investors and portfolio managers can
emulate their compeer’s investment decisions leading to market anomalies. Despite the valuable
results of this study, there are also possible extensions for further work. In particular, the study panel
should be expanded to more countries or continents. In addition, more financial stock indicators, such
as price to earnings (P/E) ratio, price to cash flow (P/CF) ratio, volatility, return on equity (ROE) and
return on asset (ROA), should be taken into consideration. Moreover, empirical analysis of the
herding methodology utilizing the time-varying beta of herding through DCC-MIDAS (Dynamic
conditional correlation with mixed data sampling) model could be used to strengthen behaviour
fnance literature.

References
www.researchgate.com
google scholar

citation
Nektarios Gavrilakis1  · Christos Floros