In this video, Andreas Hoepner, Lecturer in Banking and Finance at the University of St Andrews (Scotland), talks about the commonly held belief that integration of environment, social or governance (ESG) criteria into investment processes has a negative effect on portfolio diversification. He explains his research which contests the latter and shows that “not putting all your eggs in one basket” has three effects. Hoepner finds evidence of a “diversification bonus”.
Andrew Rudd’s (, 1981)“inescapable conclusion” that the integration of ESG criteria in investment processes must worsen portfolio diversification appears to be academic wisdom since nearly thirty years, but is it right? In his research paper “Portfolio diversification and environmental, social or governance criteria: Must responsible investments really be poorly diversified?”, Andreas Hoepner argues that Rudd’s conclusion is wrong.
Hoepner, who is also Deputy Director, Centre for Responsible Banking and Finance at St. Andrews, challenges Rudd’s conclusion with a simple theory. “Our theory connects the three drivers of portfolio diversification (1) number of stocks, (2) correlation of stocks, (3) average specific risk of stocks) to recent robust evidence on the significantly negative relationship between a firm’s ESG rating and its specific risk. We argue that while the inclusion of ESG criteria into investment processes likely worsens portfolio diversification via the first and second driver, it similarly likely improves portfolio diversification through a reduction of the average stock’s specific risk.”
Open a debate on ESG
His simple theory of negative and positive effects of ESG criteria on portfolio diversification is consistent with the available empirical evidence, which struggles to find a diversification penalty of ESG investment (Bello, 2005 ; Renneboog et al., 2007). “With our theory, we aim to open a debate on the question, if (and when) the inclusion of ESG criteria into investment portfolios really worsens their diversification as believed by Rudd. Starting this debate, we argue that negative ESG screening likely results in a diversification penalty for active mutual funds, while purely positive or especially best-in-class screening probably leads active funds to experience a diversification bonus.”
Advice for professionals
These results have implications for professionals and academics, Hoepner writes. “Mainstream active investment managers appear well advised to consider the inclusion of ESG criteria in their portfolio management process to optimize their risk management. Especially a best-in-class strategy has a high potential of improving their portfolio diversification. Similarly, pension funds should at least contemplate about the use of ESG criteria, as an ignorance of ESG criteria can in many cases violate their fiduciary risk management duties.” Hoepner advises policy makers to strengthen their support of ESG criteria in financial markets, as these cannot only decrease the ESG risk but also the financial risk of investment portfolios. “They could, for instance, require sovereign wealth funds or government pension funds to integrate ESG criteria or improve corporations’ mandatory reporting on ESG issues.”
Advice for academic researchers
As for academic researchers of ESG investment, “they might want to challenge our simple theoretical model or join a debate on when ESG criteria really worsen portfolio diversification and when they actually improve portfolio diversification. The latter could be done by extending our theoretical model or by empirically researching the relationships between ESG ratings, firm specific risk and portfolio diversification in various contexts.”
- Rudd, A. Social Responsibility and Portfolio Performance. California Management Review, 23 (4): 55-61, (1981).
- Bello, Zakri Y. “Socially Responsible Investing and Portfolio Diversification.” Journal of Financial Research 28, no. 1 (2005): 41–57.
- Horst, Jenke Ter, Chendi Zhang, and Luc Renneboog. “The Price of Ethics: Evidence from Socially Responsible Mutual Funds.” SSRN eLibrary (May 2007).
The video interview was recorded in New York City on 13 December 2011 during the ESG USA 2011 Conference “Investing for a Sustainable Economy,” organized by the Responsible Investor in association with Bloomberg.