Like many topics that encourage passion and thoughtful debate, environmental, social and governance (ESG) investing is complex and multifaceted. Unfortunately, no less than within the United States, ESG investing has develop into politicized, making a nuanced perspective and evaluation increasingly difficult.
If only there was one economic theory we could use to maneuver beyond the binary, politicized landscape, it will help us understand the several impacts of ESG evaluation on risk and expected return, and the way such considerations inform portfolio construction should influence different investors or not.
Luckily, we’ve such a theory – the Popularity Asset Pricing Model (PAPM)!
While most finance and investment professionals are aware of the Capital Asset Pricing Model (CAPM) and Harry Markowitz’s mean-variance optimization, PAPM knowledge is way more limited.
In the CAPM, each investor formulates his investment problem in Markowitz’s mean-variance model. It assumes that markets are perfectly efficient and that every one investors “agree” on the danger and expected returns of all assets. This means everyone arrives at the identical efficient frontier and the identical Sharpe-maximizing market portfolio, which is then leveraged or unleveraged depending on risk tolerance. Mean-variance optimization becomes unnecessary, and investors haven’t any different “tastes” beyond their risk tolerance, resulting in numerous leverage.
Empirically, there are many anomalies where long-term average returns deviate from the returns from the CAPM. In particular, Eugene Fama and Kenneth French have proposed various hidden risk aspects to clarify deviations from the CAPM. your paper “Disagreement, tastes and asset prices” marks a change of perspective. They describe “disagreement” and “tastes” because the two missing ingredients of the CAPM that impact asset prices. Disagreement is the concept that people have different capital market expectations and tastes are the investor’s individual preferences over and above risk tolerance for various attributes and characteristics.
The PAPM integrates each components right into a generalized equilibrium asset pricing model. Each investor solves a mean-variance optimization problem based on his capital market expectations, which include an extra term that captures how much profit the investor gets from a portfolio that focuses on his preferred characteristics and moves away from those he does don’t like. At the identical time, this term allows for any degree of like and dislike. For example, an investor might like some green energy but hate handguns. When enough investors have a robust positive or negative feeling a few property, it affects asset prices. Over long periods of time and consistent with the PAPM, many CAPM anomalies suggest that there could also be a return premium for the avoided feature.
Under PAPM, individual investors may each have their very own opinion on how ESG characteristics or sub-ESG characteristics influence expected risk and return. They might also have different preferences regarding the characteristics they need reflected of their portfolio. Likewise, they will have a look at almost any given characteristic from a pecuniary and non-pecuniary perspective.
For example, genetically modified organisms (GMOs) evoke different views amongst investors. From a financial perspective, some may imagine that demand and price for GMOs will rise or fall and subsequently future returns will probably be higher or worse than the market.
From a non-financial perspective, some investors may prefer investing in firms that produce GMOs because they imagine it will help feed humanity and end world hunger. Others should want to avoid such firms because they fear that GMOs could endanger biodiversity.
Such views and preferences may or will not be mutually exclusive and sometimes contradict expectations. An investor might imagine that demand and costs for GMO products will decline, but still think that fighting world hunger is an excellent thing. Another investor may expect a rise in price and demand, but believes it’s a small price to pay to stop GMOs from potentially harming the environment.
Investors are complex. As practitioners, we must always search for foundational theories and models that reflect reality and have increasingly less restrictive assumptions. True ESG believers might imagine that ESG investing can save the world and improve a portfolio’s expected risk and return. ESG skeptics, then again, may imagine that taking ESG considerations into investment decisions needs to be illegal. Both perspectives are flawed. The expectation that choosing only investments with high ESG scores will end in higher returns is misguided, as is limiting using ESG information in investment evaluation and portfolio construction.
Finally, investors who ignore ESG considerations are at an information drawback and are more likely to underperform. This also applies to those that, for certain reasons, only spend money on securities with good ESG scores or who avoid such securities for certain reasons. On the opposite hand, investors who consider ESG aspects and ignore them are more likely to outperform.
Investors who apply ESG considerations and taste preferences are more likely to underperform, but from a PAPM perspective they need to own personalized, utility-maximizing portfolios! For those without taste or strong financial views, this “personalized” portfolio is usually a passive, low-cost portfolio.
Therefore, individual investors and people who manage them should construct personalized portfolios that reflect their views and preferences to the extent that they’ve them.
When it involves institutional portfolios, those that manage public pension plans or other large portfolios that serve diverse groups of individuals shouldn’t limit the investment universe based on their personal preferences. This is particularly true when those the portfolio serves haven’t any other selection. To the extent that financial aspects, ESG aspects or other aspects may affect risk and return, managers of public capital should consider all applicable information and shall not be prevented from using applicable ESG information. This could include trying to take advantage of the influence of taste by buying unpopular assets and avoiding overly popular assets.
The PAPM takes us beyond blanket strokes and divisive rhetoric by explaining how and the way it influences personalized portfolio construction and ultimately equilibrium asset prices. It allows for a world of various views and preferences and provides a practical, theory-based framework for navigating this world.
When it involves ESG investing, we must recognize that not everyone agrees.
Further reading on PAPM
Idzorek, Thomas M. and Paul D. Kaplan. “Forming ESG-oriented portfolios: A popular approach.” .
Idzorek, Thomas M., Paul D. Kaplan and Roger G. Ibbotson. “The CAPM, APT and PAPM.” Social Science Research Network (SSRN).
Idzorek, Thomas M., Paul D. Kaplan and Roger G. Ibbotson. “The Popularity Asset Pricing Model.” Social Science Research Network (SSRN).
Photo credit: ©Getty Images / Witthaya Prasongsin
