Chapter 12: Extending Modern Portfolio Framework with ESG Dimension for the Responsible Investment

Purpose: This study focuses on the business case of Environmental, Social and Governance (ESG), namely its economic benefits and long-term value creation by attracting environmental-friendly and socially responsible investors.

Methodology: The central result of the von Neumann–Morgenstern (VNM) expected utility theory is that the optimal strategy under uncertainty is given by maximising the expected utility. The study introduces a second utility function to represent externalities. Total utility can be derived by a sum of the two functions where h is a scalar value which indicates to what degree the actor is interested in maximising the utility of externalities. The payouts could be set by ESG scores for the given companies, then the whole equation can be solved for simple cases such as the normal case.

Findings: By extending the traditional risk/return MPT framework to account for the additional utility of contributing towards externalities (in this case specifically ESG goals) the utility maximisation algorithm can be applied to the ESG dimension in a holistic manner and not as a separate filter on the investment universe nor a synthetic boost to expected returns.

Implications: Portfolio and asset managers can more efficiently optimise for consumer risk, return and sustainability preferences, allowing access to the widest possible investment universe while at the same time delivering an optimal bespoke solution for the specific sustainability preferences of the investors.

Future research: How to measure investment’s sustainability impact and what is the best way to estimate that. How to determine monetary impact of damages and externalities. Estimation of Hamilton’s coefficient.