Systematic ESG Risk and Decision Criteria for Optimal Portfolio Selection

Abstract

As institutional investors’ herding on ESG investing can account for joint movement in security prices, we build a framework to identify the systematic ESG risk factor through the orthogonal spread between a broad market and an ESG-screened index returns. We suggest the double-index model and extended-criteria decision rule for optimal portfolio selection. Applying the decision rule to US equity mutual funds shows that ESG integration to portfolio optimization can enhance the portfolio’s ESG quality and improve the portfolio's risk-adjusted return during the out-of-sample period. Our double-index model can help investors analyze how the systematic ESG risk is relevant to future risks or returns and provide a tractable empirical approach for recent theoretical analyses on ESG factor investing.

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