Is the stock market discounting the impact of ESG factors? A portfolio management perspective.

In recent years, the focus of investors and fund managers on adopting Environmental, Social, and Governance (ESG) practices has grown significantly, reflecting a paradigm shift in how investment strategies are conceived. This trend is deeply intertwined with the broader framework of socially responsible investing (SRI), wherein integrating ESG factors into financial decision-making is seen not only as a means to promote sustainability but also as a strategy to enhance long-term financial returns. Sustainable and responsible investment (“SRI”) is a long -term oriented investment approach which integrates ESG factors in the research, analysis and selection process of securities within an investment portfolio. It combines fundamental analysis and engagement with an evaluation of ESG factors in order to better capture long term returns for investors, and to benefit society by influencing the behaviour of companies. (Eurosif’s Board 2016). The global rise in awareness of climate change, social inequality, and governance lapses has prompted investors to view ESG considerations as critical elements in evaluating a company's overall value and risk profile. Already in recent decades, investors consider not only risk-adjusted returns in their investment choices, but also extra-financial criteria such as environmental, social and governance scores issued by rating companies. The emphasis on aligning financial goals with broader societal and environmental objectives represents a fundamental transformation in capital allocation practices. Larry Fink, CEO of BlackRock, believes that climate risk data is compelling investors to rethink the core principles of modern finance. In his 2020 annual letter to shareholders, he emphasized that climate risk is investment risk and expressed his commitment to placing sustainability at the center of his investment strategy. Research on the relationship between ESG practices and financial performance has evolved along two primary strands. The first emphasizes the value-generating potential of ESG investments, asserting that sustainable practices can enhance returns and reduce risk. Notable contributions, such as those by Friede et al. (2015) and Clark et al. (2015), provide substantial evidence supporting this perspective. More recently, Bauer (2021) sets out to understand whether sustainability is a priority criterion when choosing personal investments and how much individuals are willing to sacrifice in terms of return, arriving at the thesis that investors see sustainable investments as a strategy to improve portfolio resilience in the long run, rather than as an opportunity for immediate gain. Conversely, the second strand is more critical, questioning the efficacy of ESG strategies in delivering superior financial outcomes. Revelli and Viviani (2015), for instance, argue that the relationship between ESG and financial performance is not straightforward and may be influenced by various contextual factors. La Torre et al. (2020) conducted an in-depth analysis of the impact of ESG scores on the stock performance of companies included in the Eurostoxx50 index. Their findings revealed that ESG commitments and scores did not exhibit a significant influence on the companies' share performance. This suggests that, within this group of leading European firms, the integration of environmental, social, and governance factors into business strategies may not necessarily translate into measurable financial returns or stock market advantages in the short to medium term. Recent studies, such as those by Gavrilakis and Floros (2023), provide further nuance, indicating a generally positive relationship between ESG performance and stock returns while highlighting significant disparities in how ESG factors are integrated into market valuations. These findings suggest that economic and behavioural variables play a pivotal role in shaping the impact of ESG practices. Despite the increasing recognition of ESG's importance, traditional investment valuation methods often fail to fully integrate ESG information, leading to biased assessments. Above all approaches focusing predominantly on financial metrics derived from historical data, produce underestimations or misrepresentation of the implications of ESG-related risks and opportunities. This is compounded by several structural and methodological limitations, such as the lack of standardized ESG data, an overemphasis on short-term metrics, and the difficulty of quantifying intangible ESG factors like reputation or social impact. Another issue concerns the way ESG information are integrated with financial information especially in portfolio analysis, to this hand in this field exclusion/ inclusion methods imposes benchmarks from portfolio management. These methods, by working on firms’ selection on the basis of ESG criteria’s introduced subjectivity in portfolio construction, making them poorly replicable and efficient. Same hold true for methods that penalize ESG non-compliant firms as in Pedersen et all. (2021). This underscores the need for a more rigorous, systematic approach to evaluating the influence of ESG factors on financial markets, particularly in light of their growing relevance. To address these issues, we propose the use of the Black-Litterman (B.L.) model, an advanced approach for portfolio optimisation that combines market returns with investors' subjective opinions. This model addresses the limitations of traditional methods, such as their extreme sensitivity to historical data, by placing greater emphasis on contemporaneous views and market dynamics. Additionally, the B.L. approach produces portfolio constructions that are more feasible and realistic, avoiding the extreme allocations often seen in traditional frameworks.. In this research, the B.L. model is adapted to integrate the ESG profiles of companies. This is achieved by incorporating a matrix that captures variations in ESG valuations for each security. Specifically, the B.L. framework, originally designed to incorporate investor views into the portfolio construction process, is modified to replace views with an ESG indicator. Future expected returns are associated with this indicator, starting with the penalization of greener securities (assigning them a negative expected return) and subsequently promoting them (assigning a positive expected return).This approach aims to offer deeper insights into how sustainable practices influence investment decisions and long-term returns. The results align with the predominant findings in the literature, suggesting that incorporating ESG information into investments does not necessarily lead to higher profitability. Interestingly, the portfolio constructed to penalize the more ESG-virtuous assets proves to be more profitable than the one assigning higher expected return to greener assets. Nonetheless, this ESG-focused portfolio still outperforms the benchmark mean-variance optimization portfolio.