Responsible Investing: The ESG-Efficient Frontier

42 Pages Posted: 18 Oct 2019 Last revised: 7 Nov 2019

See all articles by Lasse Heje Pedersen

Lasse Heje Pedersen

AQR Capital Management, LLC; Copenhagen Business School - Department of Finance; New York University (NYU); Centre for Economic Policy Research (CEPR)

Shaun Fitzgibbons

AQR Capital Management, LLC

Lukasz Pomorski

AQR Capital Management, LLC

Date Written: October 1, 2019

Abstract

We propose a theory in which each stock’s environmental, social, and governance (ESG) score plays two roles: 1) providing information about firm fundamentals and 2) affecting investor preferences. The solution to the investor’s portfolio problem is characterized by an ESG-efficient frontier, showing the highest attainable Sharpe ratio for each ESG level. The corresponding portfolios satisfy four-fund separation. Equilibrium asset prices are determined by an ESG-adjusted capital asset pricing model, showing when ESG increases or lowers the required return. Combining several large data sets, we compute the empirical ESG-efficient frontier and show the costs and benefits of responsible investing. Finally, we test our theory’s predictions using commercial ESG measures, governance, sin stocks, and carbon emissions.

Keywords: portfolio choice, ESG, socially responsible investing, impact investing, sustainable investing, CSR

JEL Classification: D62, G11, G12, G14, G23, G34, G4, M14, Q01, Q5

Suggested Citation

Pedersen, Lasse Heje and Fitzgibbons, Shaun and Pomorski, Lukasz, Responsible Investing: The ESG-Efficient Frontier (October 1, 2019). Available at SSRN: https://ssrn.com/abstract=3466417 or http://dx.doi.org/10.2139/ssrn.3466417

Lasse Heje Pedersen (Contact Author)

AQR Capital Management, LLC ( email )

Greenwich, CT
United States

Copenhagen Business School - Department of Finance ( email )

Solbjerg Plads 3
Frederiksberg, DK-2000
Denmark

New York University (NYU) ( email )

Stern School of Business
44 West 4th Street
New York, NY 10012-1126
United States

Centre for Economic Policy Research (CEPR) ( email )

London
United Kingdom

Shaun Fitzgibbons

AQR Capital Management, LLC ( email )

Greenwich, CT
United States

Lukasz Pomorski

AQR Capital Management, LLC ( email )

Greenwich, CT
United States

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