Responsible Investing: The ESG Efficient Frontier

  1.  The benefit of ESG information can be quantified as the resulting increase in the maximum Sharpe ratio (relative to a frontier based on only non-ESG information). The cost of ESG preferences can be quantified as the drop in Sharpe ratio when choosing a portfolio with better ESG characteristics than those of the portfolio with maximum Sharpe. Type-A investors choose the portfolio with the highest SR, that is, the tangency portfolio using ESG information in Fig.1, Panel A. Type-M investors have a preference for higher ESG, so they choose portfolios to the right of the tangency portfolio, on the ESG-efficient frontier. Type-U investors may choose a portfolio below the frontier, because they compute the tangency portfolio while ignoring the security information contained in ESG scores (they condition on less information). Empirically, when ESG is proxied for by a measure of governance (G) based on accruals and no constraints are used, the maximum SR is achieved for a relatively high level of ESG. When realistic constraints (i.e.screening out stocks with the weakest ESG characteristics) are imposed on the portfolio, there is a downward shift in the ESG-SR frontier. 
  2. Equilibrium asset returns satisfy an ESG-adjusted capital asset pricing model (CAPM), showing when higher ESG assets have lower or higher equilibrium expected returns. This model is the first to explicitly model heterogeneity in how investors use ESG information. This heterogeneity results in a range of possible equilibria depending on the relative importance of each investor type, leading to a relation between ESG and expected returns that is positive, negative, or neutral.
  3. The costs and benefits of responsible investing are estimated via the empirical ESG-efficient frontier based on environmental (E) and governance (G) measures and show how ESG screens can have surprising effects.
  4. Equilibrium predictions are tested using four ESG proxies (E- how green a company is with each company’s carbon intensity; S with a sin stock indicator defined in Hong and Kacperczyk (2009), G-how (un)aggressive a company is in its accounting choices based on the accruals in the financial statements (Sloan, 1996) and a measure of overall ESG with the aggregate ESG score produced by MSCI) providing a rationale for why certain ESG measures predict returns positively (some aspects of governance) and others negatively (non-sin stocks, a measure of S) or close to zero (low carbon emissions, an example of E, and commercial ESG measures).
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