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Modern portfolio theory tends to treat investments as statistical objects that need to be combined in optimal ways to achieve risk and return objectives. In the past few decades, investors have seemed to be more interested in treating securities as more than just statistical objects—equities represent ownership interests in companies that interact with a variety of stakeholders (in the present and the future), and investors have preferences over how the companies behave and how their securities’ prices behave. Investors also believe that company behaviors affect returns.
Although it has gone through a few incarnations, an increasingly popular rubric for many of these dimensions of investments is ESG—the environmental, social, and governance dimensions of the companies in which investors invest. Branch, Goldberg, and Hand (2019) provided a nice illustration of a few ways in which ESG considerations can be reflected in portfolios. ESG considerations, broadly, are used in two ways:
1. ESG to reflect investors’ values. Just as consumers value different dimensions of goods and consider more than just price when making purchase decisions, investors can consider more than just the statistical properties of their investment universe. Consumers enjoy consumer surplus when they value an item more than they value the money they part with to purchase a good. Investors can also enjoy an investor surplus when there is a wedge between the value they place on an investment—which may transcend the volatility and expected return dimensions of the investments—and the price they pay in the market for the investment (Jacobsen 2011). ESG investors can avoid certain securities, deliberately include certain securities, and make overweight/underweight decisions based on the ESG characteristics of firms to reflect or advance the investors’ values.
2. ESG as a form of risk management. There may also be risk and return implications of the ESG features of a company. Portfolio managers and financial analysts spend a good deal of their time on financial statement and market analysis to uncover favorable risk–return opportunities, but they also evaluate other risks that may be more qualitative in nature. Limkriangkrai, Koh, and Durand (2017) showed that (at least for Australian companies) E, S, and G can be indicators of future financing decisions of firm management, which affects risks. Within the Ellsberg (2016) risk framework, the quantitative...