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The trade-off between ESG screening and portfolio diversification in the short and in the long run

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Abstract

This paper empirically investigates the performance of portfolio screening strategies based on ESG (Environmental, Social, Governance) scores, by testing three main hypotheses motivated by the introduction of sustainability considerations within portfolio theory: i) ESG screened portfolios overperform the benchmark in the long term only if the exclusion threshold is low; ii) ESG screened portfolios do not overperform the benchmark in the short term independently of the exclusion threshold; iii) ESG screened portfolios overperform the benchmark in terms of systemic risk in periods of financial distress. To this end, negative and positive screening strategies based on Bloomberg ESG disclosure scores and different screening thresholds are set up from the 559 stocks belonging to the EURO STOXX index in the period 2007–2021. The risk-adjusted performance of the ESG screened portfolios is compared with the benchmark-passive one based on Sharpe Ratio (SR) and alphas (from both a one-factor model and the Carhart four-factor model) so as to test performance over total and systemic risk respectively. Two main results emerge. First, we prove overperformance of screened portfolios only in the long run and in the presence of negative screening strategies with a low screening threshold. Second, we do not find clear evidence of over-compensation for systemic risk in all periods of financial distress, thus the alleged safe-haven property of ESG portfolios is not always there. Given the increasing attention for sustainability, our results have relevant implications for both individual investors and the asset management industry.

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Data availability

The data that support the findings of this study are not publicly available as they contain proprietary information that the authors acquired through a license. Information on how to obtain them and reproduce the analysis is available from the corresponding author on request.

Notes

  1. For an excellent review of the early literature on SRI see Renneboog et al. (2008).

  2. Overall, in 2020 total assets committed to sustainable and responsible investment strategies reached $17 trillion in the US (95% increase from 2016) and $12 trillion in EU substantially stable, mainly because of stricter sustainability standards introduced in the EU (Technical Expert Group 2020). Sustainable assets can be equity-type (e.g. stocks with high ESG rating/score) or debt-type (e.g. green bonds, social bonds). Green bonds have been mostly investigated for the existence of a green premium and its determinants (Zerbib 2019; Fatica et al. 2021), whereas the literature on social bonds is still scant and Torricelli and Pellati (2023) is the first study on the social premium.

  3. In this connection, the European debt crisis (2010–2011) had a major effect in Greece, Ireland, France, Italy, Portugal, Spain, but not all over the EU.

  4. A strand of related literature, which we do not review here for reasons of space, investigates the investors’ preferences for SRI, see e.g. recent papers by Gutsche and Ziegler (2019), Hartzmark and Sussman (2019), and Rossi et al. (2019).

  5. Unlike Pástor et al. (2021), we do not assume that shocks in the demand for sustainable assets average to zero over the long term, at least not in the period we consider (2007–2021) characterized by a significant growth in sustainable investments following initiatives promoted by both the United Nations and new requirements by Regulatory authorities. Therefore, until a new normal, in which ESG shocks average to zero, we cannot see a complete reconciliation between the realized long term overperformance of sustainable assets and their expected underperformance according to financial theory.

  6. This is also consistent with an agency perspective, executives are opportunist agents, who tend to make decisions that are consistent with their self-interest, hence a long-term perspective is able to align executives’ interests with those of society (Jensen and Meckling 1976).

  7. According to Van Duuren et al. (2016) SRI has several similarities with active management since most ESG investors also aim to beat the benchmark.

  8. The mean–variance approach can be reconciled with the expected utility theory by assuming investors with a quadratic utility function (for any return distribution) and/or normally distributed returns (for any expected utility function).

  9. The relationship between ESG portfolio returns and its systemic risk is not necessarily straightforward, in fact Varmaz et al. (2022) discuss that in the literature there are two competing approaches about ESG dimension: ESG affecting portfolio returns by means of systemic risk and ESG bringing portfolio additional returns without changing the covariance structure among the assets. They also propose a test to identify the approach explaining stock returns in a specific investment universe, but the latter goes beyond the scope of the present study.

  10. https://mba.tuck.dartmouth.edu/pages/faculty/ken.french/data_library.html

  11. While the literature lacks a universal definition of an asset's safe-haven properties, most studies associate the “safe-haven” label with risk, often referring to assets that exhibit negative (or no) correlation with other assets during extreme market conditions (Baur and Lucey 2010). However, this paper takes a different perspective by focusing on portfolio returns and adopting a risk-adjusted performance viewpoint, as supported by more recent research (e.g. Singh 2020; Lins et al. 2017).

  12. The EURO STOXX is a broad and liquid subset of the STOXX Europe 600 and represents large, mid and small capitalization companies of 11 Eurozone countries: Austria, Belgium, Finland, France, Germany, Ireland, Italy, Luxembourg, the Netherlands, Portugal and Spain.

  13. https://www.bundesbank.de/en/statistics/time-series-databases

  14. Sustainalytics, for example, has a low coverage before 2014 because before 2014, it was driven by the needs of Sustainalytics clients (Auer 2016).

  15. The objective of the paper is to compare strategies which do not require the achievement of a minimum ESG score, but rather selecting stocks according to their ESG scores in a comparative manner. Hence, by screening on the distribution of ESG scores, we can accommodate potential variations and trends over time such as the ESG market becoming more mature.

  16. Each year we consider only stocks belonging to the EURO STOXX in January of that year and only those with an ESG score in order to precisely sort them. The latter condition implies that in the first years of the period analysed a smaller number of stocks is included in each portfolio since from 2007 to 2021 Bloomberg gradually increased the number of stocks covered by an ESG score.

  17. Moreover, the equally weighting approach is very common in actively managed mutual funds (Block and French 2002).

  18. Equally weighted portfolios have equal weights (1/N) in period t = 1 when portfolios are set up, then stocks weights might change due to price movements and active management decisions. Hence transaction costs may arise because of portfolio rebalancing towards target equal weights and screening decisions. According to DeMiguel et al. (2009) portfolio turnover over month t + 1 is calculated as one-half times the sum of the absolute value of the trades across the N assets:

    $$\frac{1}{2}\sum_{j=1}^{N}|{\widehat{w}}_{j,t+1}-{\widehat{w}}_{j,{t}^{+}}|$$

    where \({\widehat{w}}_{j,t+1}\) is the percentage target weight of stock j at time t + 1 in the portfolio after rebalancing and \({\widehat{w}}_{j,{t}^{+}}\)is the percentage weight of stock j at time t + 1 in the portfolio before rebalancing. Then we average over time in order to get an indicator of average turnover for a portfolio.

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Acknowledgements

Authors wish to thank for helpful comments and suggestions: the Editor and two anonymous referees, participants to the 24th International Conference on Computational Statistics (Bologna, 2022) and participants to the 4th Corporate Governance & Risk Management in Financial Institutions International Conference (Rome, 2023).

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  1. Department of Economics, University of Modena and Reggio Emilia, Via Berengario 51, 41121, Modena, Italy

    Beatrice Bertelli

  2. Department of Economics, University of Modena and Reggio Emilia and CEFIN - Centro Studi Banca E Finanza, Via Berengario 51, 41121, Modena, Italy

    Costanza Torricelli

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Appendix

Appendix

Table 6 Portfolio descriptive statistics: 2007 – 2021
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Bertelli, B., Torricelli, C. The trade-off between ESG screening and portfolio diversification in the short and in the long run. J Econ Finan (2024). https://doi.org/10.1007/s12197-023-09652-9

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