Responsible Investing: The ESG-Efficient Frontier

How can you use ESG proxies to upgrade portfolio optimisation?

Lasse Heje Pedersen, Shaun Fitzgibbons, and Lukasz Pomorski develop a theoretical framework to integrate ESG in portfolio construction in their article « Responsible investing: The ESG-efficient frontier ».

The study introduces the ESG-SR frontier, which shows the maximum attainable Sharpe ratio for each level of ESG score, providing a framework for analysing the trade-off between financial performance and ESG preferences.

The main takeaways include:

• Optimal portfolios are characterised by four-fund separation: the risk-free asset, tangency portfolio, minimum-variance portfolio, and ESG-tangency portfolio.
• A derived ESG-adjusted CAPM can show how ESG scores affect expected returns positively or negatively depending on market conditions and investor composition.
• Screening out low-ESG stocks can lead to lower portfolio ESG scores compared to unconstrained portfolios, highlighting the nuances of ESG integration.
• Empirically, using governance (low accruals) as an ESG proxy, the maximum Sharpe ratio is achieved at a relatively high ESG level, with only a small reduction in Sharpe ratio for further ESG improvements.
• The governance proxy predicts future profitability and generates significant risk-adjusted returns of 3-7% annually, while other ESG proxies show weaker or insignificant return predictability.

This study provides a theoretical foundation for ESG integration in portfolio theory and asset pricing, offering new avenues for research on sustainable investing and a practical tool for quantifying the costs and benefits of ESG investing.

However, the model's assumptions about investor preferences and market dynamics may be dependent on the chosen proxies and sample period. Limiting the financial component to the Sharpe ratio may also oversimplify investors' real-life financial constraints.