The Cost of Insuring Against Underperformance of ESG Screened Index Funds

forthcoming in Journal of Sustainable Finance & Investment

29 Pages Posted: 23 Apr 2021 Last revised: 3 Jan 2023

See all articles by Peter Løchte Jørgensen

Peter Løchte Jørgensen

University of Aarhus - Business and Social Sciences

Mathias Danielsen Plovst

University of Aarhus - Business and Social Sciences

Date Written: November 9, 2022

Abstract

In recent years, investors have shown significant interest in responsible investment products, including sustainable and ESG screened index funds. A natural concern for prospective investors in such funds is that a sustainable fund might underperform its classical unscreened counterpart. This paper argues that this underperformance risk can be analyzed by way of an option to exchange one asset for another, and we derive a simple formula that quantifies the fair annual insurance premium for covering this risk. Only a single parameter is needed to apply the formula. This parameter -- a relative index volatility -- is readily estimated from market data. Our empirical work utilizes data from BlackRock's ETF (iShares) universe to estimate the cost of insuring against underperformance risk of some common ESG screened funds. We find that the fair cost of underperformance insurance typically corresponds to sacrificing in advance between 0.5% and 3.0% of the annual return.

Keywords: Index funds, sustainable investing, ESG, SRI, ETFs, underperformance risk, option pricing

JEL Classification: G13,G22

Suggested Citation

Jørgensen, Peter Løchte and Plovst, Mathias Danielsen, The Cost of Insuring Against Underperformance of ESG Screened Index Funds (November 9, 2022). forthcoming in Journal of Sustainable Finance & Investment, Available at SSRN: https://ssrn.com/abstract=3831924 or http://dx.doi.org/10.2139/ssrn.3831924

Peter Løchte Jørgensen (Contact Author)

University of Aarhus - Business and Social Sciences ( email )

Finance Research Group
Fuglesangs Allé 4
DK-8210 Aarhus, 8210
Denmark
+4587165117 (Phone)

HOME PAGE: http://pure.au.dk/portal/en/plj@econ.au.dk

Mathias Danielsen Plovst

University of Aarhus - Business and Social Sciences ( email )

Fuglesangs Allé 4
Aarhus V, 8210
Denmark
+4528965480 (Phone)

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