Systematic ESG Risk and Decision Criteria for Optimal Portfolio Selection

Abstract

The author suggests an alternative environmental, social, and governance (ESG) integration framework for portfolio optimization to reflect that systematic ESG risk can account for joint movement in security prices. The author’s framework consists of the double-index model, the two-layer grouping, and the extended-criteria decision rule for optimal portfolio selection. The author’s approach clearly shows how institutional investors can manage systematic ESG risk, rather than individual ESG risk, during portfolio optimization. The framework also provides a simple decision rule, a practical complement for complicated nonlinear programming algorithms, and clearly shows the security characteristics that make it desirable. Applying the framework to US equity mutual funds indicates that the approach can help investors understand how systematic ESG risk is relevant to future risks or returns, strategically manage systematic ESG risk, and improve the portfolio’s risk-adjusted return. Thus, the author’s framework can provide a tractable empirical method compatible with recent theoretical analyses on ESG factor investing.