The Cost of Insuring Against Underperformance in ESG Screened Index Funds
23 Pages Posted: 23 Apr 2021
Date Written: April 22, 2021
Investor interest in responsible investment products including sustainable and ESG screened index funds has exploded in recent years. This paper analyzes and quantifies the risk that a sustainable index fund will underperform its classical unscreened counterpart. It is shown that insurance against this underperformance risk can be thought of in terms of an option to exchange one asset for another, and it is argued that an estimate of the fair annual insurance premium to cover this risk can be obtained by a simple formula. To evaluate this formula only a single parameter - the relative index volatility - needs to be estimated from market data. In the paper's empirical part data from BlackRock's iShares universe is used to show that insurance against underperformance of the most common ESG screened funds relative to their traditional unscreened counterparts should cost what corresponds to sacrificing in advance between about 0.5% and 3% of the annual return. The insurance premium increases with the level of sustainability of the primary underlying fund.
Keywords: Index funds, sustainable investing, ESG, SRI, ETFs, underperformance risk, option pricing
JEL Classification: G13,G22
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