Portfolio Choice with ESG Disagreement: Customizing Sustainability Through Direct Indexing

The Journal of Beta Investment Strategies Direct Indexing 2023, 14 ( 3 ) 132 - 149 DOI: 10.3905/jbis.2023.1.041

Posted: 20 Jan 2023 Last revised: 6 Sep 2023

See all articles by Paul Ehling

Paul Ehling

BI - Norwegian Business School

Stig R.H. Lundeby

BI Norwegian Business School

Lars Qvigstad Sørensen

Storebrand Asset Management

Date Written: January 18, 2023

Abstract

There is strong demand for sustainable investing in direct indexing strategies. We examine implications of disagreement about environmental, social, and governance (ESG) ratings for portfolio choice by maximizing ESG scores subject to a tracking error constraint. Varying the ESG score we optimize on results in portfolios with substantial differences. Correlations between active weights of the ESG-optimized portfolios are even lower than correlations between ESG scores. Optimal portfolios have positive (negative) active weights in stocks with high (low) ESG scores, as expected, but in both cases a small market capitalization or high specific risk pulls the active weight toward zero. To attenuate ESG disagreement, we propose an optimal portfolio that maximizes the average ESG score across vendors and explicitly manages ESG disagreement by penalizing stocks with high ESG uncertainty. Increasing ESG uncertainty aversion thus means investing less in stocks with high ESG disagreement. Our solution is well suited for direct indexing clients wanting to express their sustainability beliefs.

Keywords: ESG Ratings, Direct Indexing, Sustainable Investing, Portfolio Choice, Tracking Error, Disagreement

JEL Classification: G11, G39

Suggested Citation

Ehling, Paul and Lundeby, Stig and Sørensen, Lars Qvigstad, Portfolio Choice with ESG Disagreement: Customizing Sustainability Through Direct Indexing (January 18, 2023). The Journal of Beta Investment Strategies Direct Indexing 2023, 14 ( 3 ) 132 - 149 DOI: 10.3905/jbis.2023.1.041, Available at SSRN: https://ssrn.com/abstract=4328880 or http://dx.doi.org/10.2139/ssrn.4328880

Paul Ehling

BI - Norwegian Business School ( email )

N-0442 Oslo
Norway
+47 46410505 (Phone)

Stig Lundeby

BI Norwegian Business School ( email )

Nydalsveien 37
Oslo, 0442
Norway

Lars Qvigstad Sørensen (Contact Author)

Storebrand Asset Management ( email )

Professor Kohts vei 9
Lysaker, 1366
Norway

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