Responsible Investing: The ESG Efficient Frontier

Why does it matter?

This paper attempt at bridging the gap between papers arguing that ESG hurts performance and those arriving at the opposite conclusion. The former group, based on the segmentation theories, is supported by empirical literature showing that sin stocks (alcohol, tobacco, and gaming, which can be seen as a poor S in ESG) generate positive abnormal returns. Papers in the latter group show that stocks with good governance (the G in ESG) generate positive abnormal returns as do stocks with higher employee satisfaction (part of the S of ESG). The model and empirical results proposed by the authors help explain these opposing findings: ESG is a positive return predictor if ESG is a positive predictor of future firm profits and the value of ESG is not fully priced in the market. Further, the model predicts that this relation can be weakened with ESG becoming a neutral return predictor when most investors see the value in ESG. This may lead to ESG becoming a negative predictor of returns because investors are willing to accept lower returns for more responsible stocks. 

To give some specific examples. the results of Hong and Kacperczyk (2009) arise because their measure of sin stocks (belonging to the industries related to alcohol, tobacco, and gaming) is associated with low investor demand, while the ESG measures of Gompers et al. (2003) and Edmans (2011) are related to higher firm profits in a way that the market has not fully appreciated.

The Most Important Chart from the Paper:

The results are hypothetical results and are NOT an indicator of future results and do NOT represent returns that any investor actually attained. Indexes are unmanaged, do not reflect management or trading fees, and one cannot invest directly in an index.

To understand why the ESG-SR frontier is hump-shaped, consider first the tangency portfolio known from the standard mean-variance frontier, shown in Fig. 1 Panel B. This tangency portfolio has the highest SR among all portfolios, so its ESG score and SR define the peak in the ESG-SR frontier. Further, the ESG-SR frontier is hump-shaped because restricting portfolios to have an ESG score other than that of the tangency portfolio must yield a lower maximum SR, as illustrated in Panel B.

View single page >> |
How did you like this article? Let us know so we can better customize your reading experience.

Comments

Leave a comment to automatically be entered into our contest to win a free Echo Show.