What is it about?

Constructing ESG-screened portfolios aims to reduce the aggregate ESG-risk at the portfolio level by excluding low ESG-score constituents from the selection universe. But ESG-screening imposes limits on potential diversification as well as alters risk exposures to systematic factors. Then, how does ESG-screening impact the factor-risk-adjusted performance of portfolios? To answer the question, we construct ESG-screened portfolios consisting of US equity mutual funds according to their returns-based ESG-scores. Then we conduct a performance contribution analysis for the sample period from 1999 to 2018.

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Why is it important?

We may consider that ESG-investors buy downside protection against the systematic ESG-risk. Once investors strategically choose risk exposures against conventional systematic factors, the realized factor-risk-adjusted performance of ESG-screened portfolios would turn out to be positive (adverse) when ESG-events trigger more (less) severe losses than initially expected. The result of performance contribution analysis suggests that investors need to treat the concentration level of ESG-screening as a search parameter to balance the costs and benefits of ESG-screening. The benefit of decreasing ESG risk seems to outweigh the cost of increasing diversifiable risk until about 50% of low score funds are excluded from the eligible universe. The risk contribution rises rapidly after P30, implying that the cost of limited diversification grows fast with a higher concentration of ESG-screening.

Perspectives

The expected performance of ESG-screening is likely to be determined to the extent to which the market efficiently prices the systematic ESG-risk (Jin 2018). The observation that ESG-screening significantly impacts the specific risk of well-diversified portfolios justifies ESG-screening at the portfolio level to manage the systematic ESG-risk. Now, we can more consistently reconcile the observed performance differential between ESG-investing and its counterpart within the well-established risk-return paradigm. A practical implication of this analysis is to decide a manageable size of the eligible universe regarding the implementation of ESG-screening. The limited diversification imposed by ESG-screening amounts to the cost of obtaining the downside protection. If the available universe is too narrow, investors are likely to face the high specific risk by strictly limiting the diversification among funds. An excessively broad universe may lead to dysfunctional downside protection by including greenwashed funds. This trade-off implies that investors should regard the concentration level of ESG-screening as a search parameter. In conclusion, the optimal concentration of ESG-integration depends on an investor’s willingness to deviate from the unscreened counterpart.

Ick Jin
National Assembly of the Republic of Korea

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This page is a summary of: ESG-screening and factor-risk-adjusted performance: the concentration level of screening does matter, Journal of Sustainable Finance & Investment, October 2020, Taylor & Francis,
DOI: 10.1080/20430795.2020.1837501.
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