Environmental, social and governance-efficient frontiers in an emerging market milieu

Abstract

Orientation: Environmental, social and governance (ESG) factors have evolved from peripheral significance (2000s) to a leading factor (2022) for many corporates. Most are now assigned ESG grades; which are increasingly scrutinised by investors.

Research purpose: An ideal milieu might involve rewards for responsible firms and penalties for culprits, but in a profit-driven world, this is not always true. Investors demand profitability so some trade-off is required.

Motivation for the study: Recent work to measure and optimise portfolio performance while observing corporate conscientiousness is promising: return/risk profiles comparable to those attained by unconstrained portfolios appear possible.

Research approach/design and method: Portfolio optimisation using Lagrangian calculus. As ESG scores worsen, portfolio performance should be adversely affected, and we then apply – for the first time – these portfolio optimising developments to emerging market corporates.

Main findings: ESG grades have improved over time, with both a statistically significant risk reduction and an increase in returns (the reverse for deteriorating ESG grades). As volatility increases, optimal ESG grades increase slowly as associated Sharpe ratios decrease. This could be due to an option-like reliance of inherent value upon underlying volatility.

Practical/managerial implications: With better knowledge of trends, asset managers who take ESG metrics into account can confidently assert that ESG compliant portfolios can generate healthy risk adjusted returns (Sharpe ratios) and that these values are improving over time.

Contribution/value-add: ESG compliant portfolios have become viable investments while adhering to sensible, responsible investment principles. ESG scores are improving globally, albeit at different rates.