Week 4: ESG Investing

Question 1

How to integrate ESG within 3D portfolio allocation?

Answer 1

1. Generate efficient portfolio regarding ESG and Sharpe ratio
2. Choose optimal portfolio given ESG preference
3. Adjust CAPM depending on ESG awareness

Question 2

Pedersen et al. (2021) identified three types of investors, name them.

Answer 2

Type-U investors (ESG Unaware): high-ESG stocks deliver high expected returns as type-U investors do not bid up to profit from the ESG-profitable stocks
Type-A investors (ESG Aware): they bid up the prices of high-ESG stocks to reflect their expected profits and eliminate the connection between ESG and expected returns
Type-M investors (ESG Motivated): high-ESG stocks deliver low expected returns, as ESG-motivated investors accept a lower return for a higher ESG portfolio

Question 3

In the fundamental factor model, return is explained using firms specific characteristics. Name some (8 Category’s in total)

Answer 3

Relative valuation: price/book, price/earnings, price/cash flows
Solvability: current ratio, debt/equity
Operational efficiency: inventory turnover
Profitability: ROE, ROA
Liquidity: trading volume
Macro economic: inflation, term structure of interest rates
Technical: prior 6-months return
ESG: employee relations score, environmental performance, % of women in the board, training & development expenses

Question 4

ESG-SR frontier

• Responsible investing: The ESG-efficient frontier (Pedersen et al., 2020)

Answer 4

Showing the highest attainable Sharpe ratio for each ESG level. Higher ESG does not automatically give higher SR.

Question 5

Economic factor model

Answer 5

Return is pay-off for taking economic risk times exposure to that risk (CAPM)

Question 6

What two roles does a stocks ESG score have?

• Responsible investing: The ESG-efficient frontier (Pedersen et al., 2020)

Answer 6

providing information about firm fundamentals & affecting investor preferences.

Question 7

How does every type of investor chooses their optimal investment?

• Responsible investing: The ESG-efficient frontier (Pedersen et al., 2020)

Answer 7

Type-U investors are unaware of ESG scores and simply seek to maximize their unconditional mean-variance utility.
Type-A investors choose the portfolio with the highest SR, that is, the tangency portfolio using ESG information.
Type-M investors have a preference for higher ESG, so they choose portfolios to the right of the tangency portfolio, on the ESG-efficient frontier

Question 8

Why is the US stock market highly inefficient?

• Case Closed (Haugen & Baker, 2008)

Answer 8

negative payoffs to measures of risk
negative payoffs to recent stock performance
positive payoffs to measures of current profitability
positive payoffs to measures of cheapness
positive payoffs to momentum in stock return

Question 9

What is an unexpected finding?

• Case Closed (Haugen & Baker, 2008)

Answer 9

Ten percent of stocks with highest expected return, in aggregate, are low risk and highly profitable, with positive trends in profitability

The ten percent with lowest expected return (decile 1) have exactly the opposite profile, and we find a smooth transition in the profiles as we go from 1 through 10.

Holds over all 5 periods within the 45 years