When the Homo Economicus Meets the Homo Ecologicus: A Pragmatic Approach to Reconcile Modern Portfolio Theory with Postmodern ESG Investing

Abstract

Building portfolios in an environmental, social, and governance (ESG) world—mission impossible? Communication between the homo economicus and the homo ecologicus definitely has been difficult to establish. But the discussion is now open, even if the line is still a bit noisy. Unfortunately, in the absence of proper ESG risk factors, the integration of ESG criteria remains tricky for the homo economicus. In an attempt to bridge the gap and facilitate the mass adoption of ESG investing, the authors introduce a basic combinatorial approach enabling investors to align their portfolios with their ESG preferences without sacrificing their optimality. The authors let the data talk and show that in practice investors have to choose between two available ESG strategies: a so-called marketing strategy that consists of tilting the portfolio weights toward (respectively, away from) the industries with the lowest (respectively, highest) ESG risks to exhibit a better ESG score immediately, and a so-called impact strategy that consists of tilting the portfolio weights toward (respectively, away from) the industries in which there is a significant amount of (respectively, few) ESG risks that can be managed and committed managements embracing the ESG cause. Feeling good or doing good? Investors now have to choose their camp. This is their mission, should they accept it.