Measuring and Optimizing the Risk and Reward of Green Portfolios

Posted: 24 Aug 2022

See all articles by Andrew W. Lo

Andrew W. Lo

Massachusetts Institute of Technology (MIT) - Laboratory for Financial Engineering; Santa Fe Institute

Ruixun Zhang

Peking University; MIT Laboratory for Financial Engineering

Chaoyi Zhao

Peking University

Date Written: August 17, 2022

Abstract

We study the performance of green portfolios in both the US and Chinese markets, constructed using a broad range of climate-related environmental metrics, including carbon emissions, water consumption, waste disposal, land and water pollutants, air pollutants, and natural resource use. We compare several popular long-only and long-short green portfolio construction methodologies, and find that a method based on Treynor-Black weights offers the most robust performance, thanks to its ability to quantify alphas for individual assets based on a small number of parameters. In the US, green portfolios (e.g., low-carbon portfolios) realize positive alphas in excess of Fama-French factors, of which a significant portion can be explained by an unexpected increase in climate concerns over the last decade, rather than positive expected returns. In China, investors bear a cost for holding green assets instead of brown assets over the last seven years, implying a positive carbon premium, opposite to the US market.

Keywords: Climate Finance; Carbon Neutrality; Environmental, Social, and Governance (ESG); Portfolio Construction; China

JEL Classification: C10, C20, G11, G12

Suggested Citation

Lo, Andrew W. and Zhang, Ruixun and Zhao, Chaoyi, Measuring and Optimizing the Risk and Reward of Green Portfolios (August 17, 2022). Available at SSRN: https://ssrn.com/abstract=4193010

Andrew W. Lo

Massachusetts Institute of Technology (MIT) - Laboratory for Financial Engineering ( email )

100 Main Street
E62-618
Cambridge, MA 02142
United States
617-253-0920 (Phone)
781 891-9783 (Fax)

HOME PAGE: http://web.mit.edu/alo/www

Santa Fe Institute

1399 Hyde Park Road
Santa Fe, NM 87501
United States

Ruixun Zhang (Contact Author)

Peking University ( email )

5 Yiheyuan Road
Beijing, Beijing 100871
China

HOME PAGE: http://www.math.pku.edu.cn/teachers/ZhangRuixun%20/index.html

MIT Laboratory for Financial Engineering

77 Massachusetts Ave. E62-663
Cambridge, MA 02142
United States

Chaoyi Zhao

Peking University ( email )

No. 5 Yiheyuan Road
Beijing
China

HOME PAGE: http://zhaochaoyi.github.io/

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