Does Active Management Matter in ESG Investing?

Purpose: This paper examines the impact of Environmental, Social, and Governance (ESG) screening on investment strategies, with a focus on how active and passive ESG approaches influence mutual funds’ risk exposures, return characteristics, and portfolio composition. Methodology: The analysis relies on the CRSP U.S. stock database covering the period 2013–2021 to assess mutual funds’ exposure to standard asset-pricing risk factors. Two ESG approaches are implemented: an active ESG investment strategy based on ESG scores and a passive ESG screening strategy that excludes firms failing ESG criteria. Factor loadings, return profiles, and volatility measures are used to compare ESG and non-ESG portfolios across firm size segments. Findings: The results show that, under active ESG strategies, high-ESG funds exhibit distinct factor-loading profiles relative to low-ESG funds, characterized by lower returns, reduced volatility, lower market beta exposure, and a tilt toward larger, value-oriented, and higher-quality firms. Funds with stronger social and governance scores demonstrate higher exposure to the quality factor. In contrast, passive ESG screening disproportionately excludes small-cap investment opportunities, leading to reduced diversification and higher risk in the small-cap universe, while the large-cap universe preserves most portfolio characteristics observed under active ESG strategies, except for quality exposure. Unique Contribution to Theory, Practice and Policy: This study contributes to the ESG investment literature by jointly comparing active and passive ESG strategies within a unified factor-based framework. It provides practical insights for asset managers on the diversification and risk implications of ESG implementation choices and offers policy-relevant evidence on how ESG screening criteria may unintentionally constrain capital allocation to small-cap firms.