DOES ESG INVESTING IMPROVE RISK-ADJUSTED PERFORMANCE?

 

As an ESG Consultant in Dubai, we know There are conflicting reasons why investors might want to incorporate environmental, social, and governance (ESG) criteria when building their portfolios, even though this is a growing issue for most investors. On the one hand, incorporating ESG standards lowers non-financial risks like political, regulatory, and reputational risks. Companies that fail to consider ESG factors risk facing consumer backlash, environmental catastrophes, or public relations crises.



We are an ESG Strategy consultant in Dubai, ESG fund providers are fond of supporting this idea because ESG investment is, in fact, frequently portrayed as a source of outperformance. Given that they are essential to understanding the tradeoffs involved in ESG investment, providing a qualified assessment of such views and claims in this context is crucial. After all, if ESG investing increases social welfare while lowering risk and generating outperformance, then the motivations for doing good and for doing well would be perfectly matched.

Being an ESG Reporting consultant in Dubai, this work examines whether formal empirical evidence exists to support ESG investment incentives, particularly risk and performance motivations. We discuss the actual results after conducting a theoretical analysis of the question. ESG-restricted strategies should have worse risk-adjusted performance because a more confined optimum is ex-ante dominated by a less constrained optimum. Theoretically, utilizing a captive universe to optimize a portfolio should result in worse risk-adjusted performance than using a non-constrained universe.

Therefore, compared to a portfolio that is optimally constructed without considering ESG concerns, placing a certain amount of ESG limits on investment decisions causes an opportunity cost with a potential increase in risk and reduction in performance. This is an opportunity cost because the discarded assets may be profitable. Pedersen et al. (2022) demonstrate that it is possible to compute the portfolio with the maximum attainable Sharpe ratio for each ESG score, defining the ESG-SR frontier. Investors will select the portfolio with the highest Sharpe ratio, regardless of its ESG score, if ESG is not considered.

As ESG Consultant in Dubai, the key to resolving the optimization challenge is identifying the portfolio with the highest Sharpe ratio (SR) for a particular ESG score. When comparing an efficient frontier with no restrictions on the portfolio's ESG score to one that only includes assets with an ESG score above a certain threshold, the latest efficient frontier will inevitably fall short of the former because it was created by excluding some assets. As a result, it could be more optimal.

As an ESG Strategy consultant in Dubai, ESG investing is frequently said to produce both lower risk and more robust performance, which conflicts with the main recommendation from finance theory. Assets that often have low payoffs in "bad" conditions of the world where the marginal utility of consumption is high should have a greater expected return in equilibrium, according to asset pricing theory, which holds that systematic risk is compensated. In this scenario, riskier equities with lower ESG scores ought to generate better returns, while ESG filters used to raise the portfolio's ESG score should have the opposite effect.

Location: Dubai - United Arab Emirates

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