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Among the recent changes in the investment management landscape is the growing interest of investors and asset owners in doing the right thing to ensure that companies improve their approach to environmental, social, and governance (ESG) issues. Incorporating ESG concerns into portfolio construction means that either the universe of investment candidates becomes more restricted or that additional constraints are placed on the portfolios. Both restrictions may hurt short-term performance of the ESG portfolio in comparison to non-ESG portfolios. Proponents of integrating ESG into their portfolios may do so because of their belief that the long-term risks associated with poor ESG practices are not fully incorporated into market prices, leading to superior long-term risk-adjusted returns on the ESG portfolio. Alternatively, proponents of integrating ESG into portfolios may accept the costs of adding ESG constraints as the cost of doing the right thing and enjoy the nonmonetary benefits of better ESG practices, such as leaving a better world for the next generations or improving living conditions for other people. Thus, an important challenge for investment managers is how to integrate ESG into their investment process while minimizing the potential costs imposed on portfolio construction by ESG constraints. In this study, we suggest a quantitative investment approach to integrating ESG into portfolio construction that should have negligible effects on the performance of the ESG portfolio as compared to non-ESG portfolios. We also propose a unique methodology to deal with one of the most important shortcomings of ESG data: prevalent missing data by companies that do not report relevant ESG items.
The related literature on ESG or corporate social responsibility (CSR) provides ambiguous evidence on the performance of ESG portfolios. A strand of literature examines the benefits of ESG in terms of the lower cost of capital (both debt and equity) experienced by companies with superior ESG scores as compared to companies that have inferior ESG scores (e.g., Bhojraj and Sengupta 2003; Ashbaugh-Skaife, Collins, and LaFond 2004; Bauer and Hann 2010).1 However, these results imply that, if markets are efficient and investors properly incorporate ESG into prices, future returns on better ESG firms should be lower than those on inferior ESG firms. In fact, the literature on the performance of superior ESG firms as compared to inferior...