Environmental, social, and governance (ESG) investing is complicated and multidimensional, much like many subjects that excite passion and intelligent discussion. Sadly, at least in the United States, ESG investing has become politicized, which makes complex perspective and analysis more and more challenging.
If only there were an economic theory we could use to transcend the binary, politicized terrain that would help us understand the different effects of ESG analysis on risk and expected return and how such considerations should or should not influence portfolio construction for different investors.
Fortunately, there is such a theory: the popularity asset pricing model (PAPM!).
Although most analysts in finance and investing know about Harry Markowitz’s mean-variance optimization as well as the capital asset pricing model (CAPM), PAPM expertise is far rarer.
Every investor in the CAPM creates their investment problem using Markowitz’s mean-variance approach. Assumed to be efficient, markets let all investors “agree” on every asset’s risk and projected returns. Thus, everyone arrives at the same efficient frontier and Sharpe-maximizing market portfolio; depending on risk tolerance, this is either levered or unlevered. Investors have no additional “tastes” beyond their risk tolerance. Hence, mean-variance optimization becomes pointless and varying degrees of leverage result.
Empirically, there are many anomalies wherein realized long-term average returns deviate from CAPM predicted returns. Remarkably, Eugene Fama and Kenneth French have suggested some hidden risk factors to help explain variations from the CAPM. Their work “Disagreement, Tastes, and Asset Prices,” shows a change in viewpoint. They call “disagreement” and “tastes” the two missing elements from the CAPM influencing asset pricing. Disagreement is the theory that people have varied capital market expectations and that tastes are the investor’s personal preferences beyond risk tolerance for distinct qualities and traits.
The PAPM uses both components under a generic equilibrium asset pricing approach. Based on their capital market expectations, each investor solves a mean-variance optimization problem with an additional term that reflects how much value the investor gains from a portfolio that tilts toward their favoured features and away from those they detest. That word also lets one have any degree of liking and detest at the same time. An investor might, for instance, love green energy but detest weapons. Asset values change depending on the strong positive or negative impression that enough investors have of a quality. Many CAPM anomalies over time and in line with the PAPM show that the rejected trait may develop a return premium.
Under PAPM, individual investors might all see different ways that ESG or sub-ESG traits affect predicted risk and return. They might also have distinct preferences for what traits they like reflected in their portfolio.
For instance, genetically modified organisms (GMOs) inspire different opinions among investors. From a financial standpoint, some think that demand and price for GMOs will rise or fall, affecting future returns either better or worse than the market.
From a no pecuniary standpoint, some investors might want to invest in businesses creating genetically modified organisms because they think this will help feed the planet and eradicate world poverty. Others may wish to shun such businesses if they worry that GMOs endanger biodiversity.
Such opinions and tastes might or might not be mutually exclusive and occasionally they might confound expectations. One investor could feel that demand and pricing for GMO products will drop but still consider that combating world hunger to be a deserving goal. Another investor might expect price and demand to grow but feel that it is a nominal amount to pay to stop GMOs from maybe damaging the environment.
Investors are complicated. As practitioners, we should look for basic theories and models with fewer and less constrictive assumptions that mirror reality. True believers of ESG may believe that their investing can help to rescue the planet and enhance the predicted risk and return of a portfolio. Conversely, ESG critics could believe that considering ESG factors while making investments should be against the law. Both viewpoints have flaws. Just as misguided as limiting the use of financial ESG information in investment analysis and portfolio design is the belief that choosing just investments with high ESG scores will result in greater returns.
Investors who overlook wealthy ESG factors do, after all, run an informational disadvantage and are likely to underperform. Likewise are those who shun such products for non- monetary reasons or who merely invest in securities with strong ESG ratings for non- monetary reasons. Conversely, investors that neglect non- monetary ESG aspects and take wealthy ones into account are probably going to over perform.
While from a PAPM standpoint investors who apply ESG considerations and have non- monetary benefits tastes should own individualized, utility-maximizing portfolios; they are likely to underperform otherwise. For those without strong financial ideas or tastes, that “personalized” portfolio will frequently be a passive, low-cost one.
To the extent that they have them, then, individual investors and those who service them should create customized portfolios reflecting their opinions and preferences.
Regarding institutional portfolios, those who oversee public pension systems or other sizable portfolios catering to different categories of people should not restrict the investment universe depending on their own inclination. This is particularly true in cases when individuals with portfolio targets have no other option. Stewards of public capital should assess all relevant information. They should not be limited from using relevant enriched ESG information, to the extent that any fruitful element, ESG, or otherwise, may affect risk and return. This could include avoiding too popular assets and trying to leverage the influence of tastes by acquiring unattractive ones.
The PAPM explains how disagreement and tastes affect individualized portfolio creation and finally equilibrium asset prices, therefore transcending broad strokes and controversial language. It offers a practical framework based in a theory to negotiate a world of many points of view and tastes.
Regarding ESG investing, we have to admit that opinions differ among us.
