Factor investing and ESG scores: risk-return when industry bias is corrected

This paper examines whether correcting ESG scores for industry affiliation alters the risk–return profile of factor-based investment strategies in international equity markets. Value, size, and momentum portfolios are constructed for six equity regions (the United States, the United Kingdom, Continental Europe, Japan, Canada, and Emerging Markets) over the period June 2001–June 2023, and portfolios based on conventional factor rankings are compared with portfolios that combine these rankings with an industry-relative ESG score designed to mitigate the sectoral component embedded in raw ESG ratings. The contribution of the study is to isolate the ESG signal from industry tilts and to assess its effect on portfolio allocation, volatility, and exposure to global macroeconomic risk – an interaction that the literature on ESG pricing and on factor investing has so far examined only separately. Using descriptive portfolio evidence and two-step cross-sectional asset-pricing tests, the analysis finds that industry-adjusted ESG strategies do not systematically improve average returns relative to their non-ESG counterparts, but are frequently associated with lower return volatility, particularly in developed markets. Industrial production growth and the term spread are priced sources of systematic risk in both samples, whereas the pricing of unexpected inflation, the default spread, and the Environmental Performance Index differs across the two designs. Overall, once industry effects are neutralized, ESG integration does not generate a distinct return premium but instead reshapes portfolio composition and reduces risk, with practical implications for the design of sustainable factor strategies and for the interpretation of ESG-based performance evidence.