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.
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.
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.
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.
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.
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.
ESG compliant portfolios have become viable investments while adhering to sensible, responsible investment principles. ESG scores are improving globally, albeit at different rates.
The devastating global economic impact of the coronavirus disease 2019 (COVID-19) pandemic, worrying accounts of corporate negligence and relentlessly accumulating evidence for climate change and its possible impact have all contributed to a growing awareness of individual and collective responsibility. Modern investors are increasingly calling corporations to account, punishing miscreants by reducing holdings in their stock or shunning them completely. To make informed decisions about these tactics, investors – the bulk of whom cannot possibly investigate and assess each potentially investable stock – rely on environmental, social and governance (ESG) scores provided by dozens of ratings providers – five of whom (MSCI, Refinitiv, Sustainalytics, RepRisk and Institutional Shareholder Services [ISS]) currently (2022) dominate the market (Sikochi & Serafeim
Sustainable investment increasingly relies on these ESG scores, but the investment strategies typically assemble investment portfolios using a ranked list of ‘good’ (high ESG score) stocks while ignoring portfolio completeness. Although the field has begun to flourish, literature that investigates sustainable investment asset allocation remains limited and no consolidated best-practice approach has been proposed.
Developing economies are particularly impacted by climate change and perceptions of poor governance. The literature is replete with research, which has repeatedly demonstrated that developing countries are suffering, and will suffer, considerably more than their developed country neighbours from the effects of climate change (Huang & Tian
Identifying and implementing an optimal investment solution in a mean-variance framework while heeding additional constraints (i.e. over and above ‘traditional’ constraints of simultaneously maximising excess returns and minimising associated risk) imposed by the new milieu such as selecting ‘optimal’ ESG scores for investable securities, remains. This article fills a gap in the literature by augmenting conventional portfolio selection models to embrace ESG constraints specifically for emerging markets where ESG scores are typically low compared with those observed in most developed markets. We aver that most investors still wish to generate risk-return performance obtained from conventional portfolio selection from portfolios constrained by ESG requirements and we find that for emerging economies, portfolio selection for sustainable investment and conventional portfolio selection are characterised by substantially different portfolio weights while achieving comparable levels of risk-adjusted returns. While this result has been demonstrated for developed markets, the results obtained from this research are important for sustainable investments because portfolio weights are the foundation of portfolio selection and investments. Using a sample of component stocks selected from South Africa’s Johannesburg Stock Exchange Index from 2008 to 2020, the ESG-constrained efficient frontier and the traditional efficient frontier were found to produce similar levels of risk-adjusted returns, a fortuitous endorsement of sustainable investment.
The remainder of this article is structured as follows. The next section provides an overview of the relevant literature and discusses the limitations and conclusions reached by the relevant authors. A discussion of the data used, and the methodology adopted for this research, is presented in the ‘Research design’ section, and the ‘Results and discussion’ section sets out the results obtained and considers possible outcomes derived from these results. The ‘Limitations and recommendations’ section discusses the limitations of the current work and presents some suggestions for future work, while the ‘Conclusion’ section summarises the results and observations obtained and concludes the article.
Socially responsible investing (SRI) is not a new concept. Centuries-old religious texts (such as the Jewish Torah – specifically the Islamic Quran and the biblical book of Leviticus) stipulate investment principles governing and regulating moral property ownership, fair taxation practices and appropriate interest charges for lenders. US Quakers were forbidden from profiting from the slave trade in the 18th century and US Methodists adopted the practice in the 19th century of only allowing investment in business that inflicted no harm on others (Marable
More recently, trade unions in the mid-20th century began to invest in socially relevant enterprises, such as medical facilities and housing developments; opponents of the Vietnam War in the 1970s boycotted companies that manufactured or distributed weapons (Rudd
Examples of environmental, social and governance (ESG) issues – often called the ESG pillars.
Environmental issues | Social issues | Governance issues |
---|---|---|
Climate change and carbon emissions | Customer satisfaction | Board composition |
Air and water pollution | Data protection and privacy | Audit committee structure |
Biodiversity | Gender and diversity | Bribery and corruption |
Deforestation | Employee engagement | Executive compensation |
Energy efficiency | Community relations | Lobbying |
Waste management | Human rights | Whistleblower schemes |
Based on the premise that ESG factors materially affect corporate performance and market value, the rise of ESG assets has been astonishing. Reaching US$22.8 trillion in 2016, they increased by 34% to US$30.6tn in 2018; then another 14% to US35.0tn in 2020 – roughly one-third of current total global assets under management (Bloomberg Intelligence
Google search index for the phrase (a) ‘environmental, social and governance’ and (b) ‘environmental, social and governance investing’ since 2010. The value 100 represents maximal interest.
The techniques used in sustainable investing have also progressed beyond the early ethics-based approaches, such as negative screening. These novel strategies, while still embracing the significance of ethical concerns, now focus on a more conventional investment aim, that of maximising risk-adjusted returns (Bernow-, Klempner & Magnin
Hong and Kacperczyk (
Gompers, Ishii and Metrick (
Using an extensive proprietary database of corporate social responsibility engagements with US public companies spanning from 1999 to 2009, Dimson, Karakas and Li (
Brav, Jiang, Partnoy, & Thomas (
Friede, Busch and Bassen (
Choi, Gao and Jiang (
Interest in ESG investing in emerging markets is also widespread and constantly gaining traction (Cole et al.
Limited work has also been conducted on South African ESG investment. Johnson, Mans-Kemp and Erasmus (
Despite the often-inconclusive evidence that investment in ESG stocks generate superior returns, ESG investing remains immensely popular among institutional and private investors, with no signs of abating. It remains, however, an evolving field. No universally agreed process has been devised which optimally combines profit-maximising metrics with ESG ones.
Méndez-Rodríguez et al. (
Beiting, Ioannou and Serafeim (
Qi and Li (
Utz et al. (
The data comprised a sample of some 389 global emerging economy stocks grouped into seven business sectors (financials, industrials, basic materials, energy, consumer cyclicals, technology, and academic and educational services), sourced from Reuters
Data summary by country and market sector.
Marketsector Country | Education | Materials | Cyclicals | Energy | Financials | Industrials | Technology | Total |
---|---|---|---|---|---|---|---|---|
Brazil | - | - | 4 | 1 | 9 | - | - | 14 |
Caymans | - | - | - | - | - | - | 1 | 1 |
Chile | - | - | 1 | - | 3 | - | - | 4 |
China | 4 | - | 30 | 1 | 54 | 7 | 54 | 150 |
Colombia | - | - | - | - | 2 | - | - | 2 |
Czech Rep | - | - | - | - | 2 | - | - | 2 |
Egypt | - | - | - | - | 1 | - | - | 1 |
Greece | - | - | 2 | - | - | - | - | 2 |
Hong Kong | 1 | - | 3 | - | 3 | - | 3 | 10 |
India | - | 1 | 10 | - | 18 | - | 6 | 35 |
Indonesia | - | - | 1 | - | 4 | - | 5 | |
South Korea | - | - | 9 | - | 14 | - | 8 | 31 |
Kuwait | - | - | - | - | 4 | - | - | 4 |
Luxembourg | - | - | - | - | 1 | - | 1 | 2 |
Malaysia | - | - | 1 | - | 7 | - | - | 8 |
Mexico | - | - | - | - | 2 | - | - | 2 |
Pakistan | - | - | - | - | 2 | - | - | 2 |
Peru | - | - | - | - | 1 | - | - | 1 |
Philippines | - | - | 1 | - | 3 | - | - | 4 |
Poland | - | - | 1 | - | 4 | - | - | 5 |
Qatar | - | - | - | - | 5 | - | - | 5 |
Russia | - | - | - | - | 2 | - | - | 2 |
Saudi Arabia | - | - | 1 | - | 10 | 1 | - | 12 |
Singapore | - | - | 1 | - | - | - | - | 1 |
South Africa | - | - | 2 | - | 9 | - | 1 | 12 |
Taiwan | - | - | 6 | - | 17 | 1 | 36 | 60 |
Thailand | - | - | - | - | 2 | - | - | 2 |
Turkey | - | - | 1 | - | 5 | - | - | 6 |
UAE | - | - | - | - | 4 | - | - | 4 |
While several ESG databases exist,
The ESG information provided include, on a 0 – 100 numeric scale, an ESG score, an ESG controversies overlay, a combined ESG score and the mappings of these scores to grades on an A – D scale (with additional ‘
Having selected the ESG-scored corporates, weekly share prices were assembled over the relevant period (as far back as 2007 in some cases). These share prices were then used to calculate share returns, volatility, portfolio variance-covariance matrices (where relevant) and SRs. These data were again gathered from Refinitiv (
This section presents the formulae required to plot the efficient frontier and to determine the portfolios analysed in this work. The equations are valid for the following conditions:
Short sales are allowed.
Portfolios are fully invested, that is, the portfolio weights sum to 1.
The notation from Roll (
Portfolios on the efficient frontier have an expected return
where
where
Following Merton (
To plot the efficient frontier, the portfolio variance is minimised over the weights subject to a target expected return (
where
Substituting [
From
the vector of portfolio weights for the tangent portfolio when
The return and risk for this portfolio are obtained by substituting [
The investor’s problem is that of assembling a portfolio from
The investor commences with wealth
where
and the ESG scores of the component assets are given by the vector
The assets’ average expected returns are given by
where
The investor’s utility depends on future wealth (
where
where
where
where the set of feasible portfolios is given by
The ESG-motivated investor’s portfolio problem may now be solved. The objective function depends on the ESG scores,
To use this definition of the maximal SR for each ESG level, the utility maximisation problem [
The optimal level of risk is given by
Inserting this risk level and simplifying [
ESG affects optimal portfolio choice given that ESG is included in the utility function, but the interesting result here is that we can analyse this trade-off using a part that depends only on securities (the ESG-SR frontier,
Understanding the ESG-SR frontier shows how differences in risk aversion and differences in ESG preferences can be distinguished. If a group of investors have no direct preferences for ESG (
Using the notation
We begin by analysing the evolution of average ESG scores over time of several emerging economy countries, grouped into various regions, and shown in
Environmental, social and governance (ESG) score trends for various global developing market regions: (a) Middle East and Africa, (b) Europe, (c) South America, (d) Asia, (e) Southeast Asia and (f) the emerging economy average ESG score over time. Vertical scales are different.
For all countries analysed, ESG scores increase over time, although at different rates. The average ESG score for emerging economies using the entire sample shows a pronounced linear trend, increasing at a rate of 1.63 per annum. At this rate, average emerging economy ESG scores will be comparable to current (2022) developed economy scores (~85) by the end of the 2030s. The average trend could, of course, be considerably different if rates accelerate or decelerate owing to the many contributing factors. So far, however, the slow but relentless improvement in ESG scores is encouraging.
Corporate ESG scores at individual country level using actual ESG scores rather than regional averages display substantial volatility and – in some cases – decreasing scores. This is not unexpected: companies making progress on environmental issues may have deteriorating working conditions or be governed by a weak board. A representative sample of South African stocks is shown in
Environmental, social and governance scores (and relevant trends) for representative South African stocks selected from the (a) banking, (b) insurances, (c) technology and (d) consumer cyclicals sectors over 2007–2020. Vertical scales are identical for comparison.
A well-diversified, multi-sector portfolio comprising 30 South African stocks with (current – 2022) ESG scores ranging from 14 to 81 was analysed using
Sharpe ratio as a function of environmental, social and governance score for a portfolio of 30 South African stocks.
The optimal SR for such a stylised portfolio occurs at an ESG score
Non-optimal SRs for low ESG-scored portfolios are explained by their generally higher volatility and lower returns (Sikochi & Serafeim
Non-optimal SRs for high ESG-scored portfolios require a more nuanced explanation. At this stage, however, a lack of relevant data and noisy samples prevent more than heuristic justification. It is possible that, broadly speaking, high ESG-scored companies are willing to accept lower profits in the interests of protecting the environment, improving working conditions and adhering to good governance. Note that this does not imply they are willing to forego
As average portfolio risk decreases, the SR versus ESG score graph flattens (less variation in attainable SRs over the range of ESG scores). In addition, as portfolio risk decreases, the locus of the optimal SR versus ESG moves down (decreasing SR) and to the right (increasing ESG) as shown in
Sharpe ratio versus environmental, social and governance score as a function of volatility (increasing from the uppermost to lowest curve) in (a) two and (b) three dimensions.
It is not obvious why the locus of the optimal SR/ESG score – as a function of portfolio volatility – should behave in this way. The results indicate that, unsurprisingly, portfolios with higher volatilities in general have lower ESG scores, but they also show that high volatility portfolios can generate higher SRs (all else being equal). It is possible that this could be an artefact of the risk/return relationship like that observed in option pricing (increases in volatility precipitate higher option prices because the option has a higher likelihood of exercise): higher volatility ESG portfolios generate higher SRs as they may generate higher returns. This possibility requires deeper interrogation when more data become available.
Using portfolio constituent weights from
Global and environmental, social and governance (ESG)-efficient frontiers with associated capital market lines (CMLs), minimum variance portfolios and tangent (optimal) portfolios. In (a) optimal portfolios have similar return levels but the ESG portfolio has higher volatility (lower Sharpe ratio) and in (b) optimal portfolios have similar risk levels, but the ESG portfolio has lower returns (again, a lower Sharpe ratio).
Empirical evidence shows that as portfolio ESG scores increase (all else equal), returns deteriorate and risk (volatility) increases. Examining country-specific portfolios comprising the ESG-rated companies in our sample, this was indeed found to be the case: the ESG-efficient frontier moves southeast (down and to the right) away from the global efficient portfolio (in each case comprising most – or all – of the stocks which constitute the country’s principal stock exchange index). These shifts are illustrated in
Return-risk loci for the global efficient frontier score and environmental, social and governance (ESG)-constrained frontiers as a function of ESG scores: (a) as the ESG score deteriorates, the maximal tangent portfolio moves down and right (southeast), that is, lower returns and higher risk and (b) time evolution of ESG-constrained efficient frontiers for South African portfolios. ESG monotonically increases over the period from 50 to 60. Grey arrow indicates the direction of improving ESG scores and their effect on the ESG efficient frontier’s tangent portfolio.
The rise in significance of ESG criteria has become impossible to ignore. Social responsibility, once the purview of militant activists, has moved into the mainstream. Environmental, social and governance quantification is now widespread, which is an important development because management is impossible without measurement. Financial statements now analyse and report on ESG developments and investors avoid firms guilty of reckless behaviour. Asset managers must embrace these developments and structure portfolios accordingly, but in the absence of an established, robust mathematical structure, this has proved difficult to impossible.
The emergence of novel asset allocation techniques which borrow heavily from the tried and tested Markowitz efficient portfolio framework, then, is welcome, but acceptance and implementation have been slow. Like most new approaches to old-but-developing problems, many years of data are required to prove reliability and robustness. While such efforts are gathering steam in developing markets, emerging markets suffer from even fewer data and later installation. This work fills the gap by adapting new approaches and applying these to global emerging market data for the first time.
Future investigations should explore other ESG metrics and their ongoing impact on portfolio efficiency and risk-adjusted return optimality. A detailed comparison of the results obtained here and those assembled from developed economies would also be a welcome addition to the ongoing pursuit of profits while embracing responsibility to the planet, employees and the wider community.
We find that ESG scores have been improving inexorably (but slowly) in the emerging market milieu since ESG scores were introduced in 2007. At this current growth rate, emerging markets will enjoy similar ESG scores to their developed nation counterparts by the late 2030s, although many interacting factors could accelerate or slow that progress. We find that, at present (2022), optimal risk-adjusted portfolio returns are not necessarily associated with those portfolios having the highest ESG scores. There is a maximal SR portfolio attainable with a given portfolio ESG score, but both higher and lower ESG scores result in lower SR portfolios. We speculate that while the lower ESG/lower Sharpe ratio observation is intuitive, decreasing Sharpe ratios for increasing ESG scores is more nuanced and requires further investigation. This observation could be due to diminished returns for very high ESG-scored firms who plough profits into employee working conditions and environmental projects, rather than their bottom lines. While good for the planet and their employees, such firms do not (yet) generate superior returns to their less responsible peers, but this is persistently improving over time and the distinction between global efficient portfolios (which ignore ESG scores) and ESG-efficient portfolios is constantly narrowing.
We are grateful for the valuable insights and input provided by members of Riskworx, South Africa.
The authors declare that they have no financial or personal relationships that may have inappropriately influenced them in writing this article.
F.B. was responsible for the conceptualisation, writing, analytics and visualisation of this article. G.v.V. was responsible for supervision, analytics and visualisation of the study.
This article followed all ethical standards for a research without direct contact with human or animal subjects.
This research received no specific grant from any funding agency in the public, commercial or not-for-profit sectors.
All data are available from Reuters
The views and opinions expressed in this article are those of the authors and do not necessarily reflect the official policy or position of any affiliated agency of the authors.
Country | Comparison of means (ESG scores) | Comparison of variances | Comparison of means (returns) |
---|---|---|---|
Egypt | 2.54** | 4.46*** | 2.99*** |
Kuwait | 2.39** | 2.76** | 2.99*** |
Qatar | 2.22** | 5.11*** | 2.40** |
Saudi Arabia | 4.73*** | 4.35*** | 2.81*** |
South Africa | 2.16** | 3.41** | 3.20*** |
UAE | 2.92*** | 4.37*** | 1.98* |
Turkey | 4.54*** | 3.93*** | 4.01*** |
Czech Republic | 3.98*** | 1.89* | 4.20*** |
Greece | 2.33** | 4.67*** | 4.67*** |
Poland | 3.65*** | 3.78*** | 3.96*** |
Chile | 2.98*** | 4.97*** | 3.44*** |
Brazil | 3.42*** | 2.32* | 4.33*** |
Colombia | 3.01*** | 4.07*** | 1.32* |
Mexico | 4.33*** | 3.31** | 2.42** |
Peru | 4.21*** | 4.66*** | 2.35** |
Cayman Islands | 2.61** | 3.08** | 2.68** |
China | 2.59*** | 5.39*** | 2.46** |
Hong Kong | 3.95*** | 4.95*** | 4.82*** |
India | 3.19*** | 3.27** | 2.69** |
Pakistan | 2.32** | 3.43** | 2.75*** |
Russia | 2.60** | 4.92*** | 2.46** |
Indonesia | 3.91*** | 4.33*** | 2.17** |
Malaysia | 2.08** | 4.93*** | 3.07*** |
Philippines | 4.06*** | 2.53** | 1.00* |
Singapore | 4.34*** | 3.74*** | 2.33** |
South Korea | 4.62*** | 4.61*** | 3.33*** |
Taiwan | 2.16** | 3.09** | 4.00*** |
Thailand | 2.95*** | 4.35*** | 2.82*** |
ESG, environmental, social and governance.
1%, 5% and 10%
An ESG score is a metric which reflects a company’s performance based on several environmental, social and governance indicators. Generating an ESG score involves evaluating a company’s adherence to and observance of these indicators using simple numerical scales and then aggregating these individual scores into a single appraisal. These are then mapped to an ESG rating much like a credit rating is assigned by credit rating agencies. Like credit ratings and the agencies that provide them, ESG ratings and ESG raters employ different approaches, thresholds, and scales and thus different outputs for the same company.