ESG disclosure and portfolio returns: evidence from the Indian equity market

Abstract

There has been increased emphasis on responsible investing worldwide. This study contributes to the existing literature by examining whether ESG serves as an additional factor beyond FFTF model in Indian equity market. The study has used prominent risk models such as traditional Fama-French three factor (FFTF) model, Augmented FFTF model, by replacing value with ESG factor, Modified FFTF model, by replacing value with individual ESG dimensions- Env, Soc and Gov, and a four-factor model by including ESG factor alongside FFTF to obtain the explanation about the cross-section variation in the portfolio returns. The results demonstrate that the average excess returns across portfolios are largely positive indicating the presence of strong size, value, ESG, Env, Soc, and Gov effects in Indian equity market, with small-cap portfolios consistently outperforming large-cap portfolios. The findings of the study further indicate that four-factor model that includes ESG factor provides superior explanation across all characteristics-sorted portfolios except for MC_ESG as the alpha estimates are indistinguishable from zero and produces higher R2 value relative to the traditional three factor model. Further, these findings are corroborated by the GRS test results. Notably, the MFFTF model incorporating Gov factor offers the strongest explanatory power, suggesting its relevance as a determinant of stock returns in the Indian market compared to the other two individual components such as Env, and Soc. Overall, this study will help investors address sustainability-related risks and changing market preferences by integrating ESG factor into their investment decision.