Responsible Investing: The ESG Efficient Frontier

What are the Research Questions?

The 2018 Global Sustainable Investment Review reports over $30 trillion invested with explicit ESG goals as of the beginning of 2018. In the words of the authors:

There is a clear tendency for many investors to own ethical companies in a saintly effort to promote good corporate behavior while hoping to do so in a guiltless way that does not sacrifice returns.

To empower future investors in the ESG space we have made a considerable effort to report on the academic research findings in this space. For further reading on ESG check out some of our previous work:

Research hasn’t conclusively determined if incorporating ESG components into a portfolio adds value or not. In short, there are intense debates surrounding the basic question of, “Does ESG improve risk-adjusted returns?”

This paper attempts to reconcile the opposing views by introducing a framework to evaluate the costs and benefits of responsible investing.

What are the Academic Insights?

The authors identify three types of investors:

  • Type-U (ESG-unaware) investors are unaware of ESG scores and simply seek to maximize their unconditional mean-variance utility.
  • Type-A (ESG-aware) investors also have mean-variance preferences, but they use assets’ ESG scores to update their views on risk and expected return.
  • Type-M (ESG-motivated) investors use ESG information and also have preferences for high ESG scores.

By showing that the investor’s problem can be reduced to a trade-off between ESG and Sharpe ratio, the authors find the following:

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