Enhancing Environment-driven Portfolios with Traditional Factors

This chapter investigates the efficacy of combining traditional factors with environmental data when building optimal equity portfolios. Investors are increasingly concerned about the environmental footprint of their equity portfolios. The chapter proposes to exploit traditional firm attributes such as market capitalization, price-to-book ratio or volatility in order to enhance a portfolio optimization scheme that includes a reward for the environmental score of the portfolio. It details the theoretical setting by proposing two types of environmental, social, and governance (ESG)-driven optimization: the traditional approach first, followed by an alternative that relies on firm characteristics to estimate the expected returns and covariance matrices. The investment universe consists of US firms that disclose ESG data. The chapter analyzes the sensitivity to sample size and chooses an alternative benchmark. It provides new evidence that sustainable investing is neither necessarily very costly from a financial standpoint, nor extremely useful to generate abnormal profits.