Balancing Returns and Responsibility: Evidence from Shrinkage-Based Portfolios

Abstract

We study the impact of environmental, social, and governance (ESG) scores on out-of-sample portfolio gains. Our shrinkage approach accommodates investors with heterogeneous beliefs and enables us to assess the incremental value of ESG relative to market information in a data-driven manner. We find that ESG-based portfolio rules do not consistently outperform market-based strategies in terms of risk-adjusted returns. Moreover, investors concerned with ex-post ESG standing can achieve comparable goals using return-based rules alone without integrating ESG scores into their portfolio choices, suggesting that these scores are a second-order priced information. Our paper raises questions about the efficiency of ESG-driven portfolios and their long-term financial stability.

Keywords: ESG Investing, Portfolio Selection, Estimation Risk, Ex-Post Efficiency, Covariance Shrinkage

JEL Classification: C13, C61, G11