The social responsibility of business is to increase its profits. This is frequently quoted from Milton Friedman, who responds with his doctrine to a corporate’s social responsibility towards its shareholders. This former economic approach highlights therewith the entrustment of investments solely for shareholder value maximization and declares a minimum of social responsibility towards the public, the society, and the environment. Based on a traditional background, investors have pursued financial returns as a measure of their investment outcomes.
Contrary to earlier deliberations, the mutual fund industry extended an investment typology in the United States (U.S.) in the seventies, which incorporates environmental and social criteria, and later on governance aspects in investment decisions.
Successively, investors started to track the supportive and harmful corporate activities on society and environment they had invested in. This new approach called sustainable investing describes mutual funds striving for financial success while honoring the relationship with and the impact on stakeholders.
The concept challenges the classical risk-return relationship that either maximizes the expected return for a certain level of risk or minimizes risk for a favored level of expected return.
Nowadays, sustainable issues such as global warming and child labor do reject earlier attitudes of investment approaches reflected by the quote of Milton Friedman introducing an alternative view on investment policy.
Since stakeholder worldwide are raising concerns about sustainable issues, expectations towards financial markets are increasing addressing these concerns and deliberating on them. The overall perception changes from capital maximization to the idea that the highest use of capital is to make money working beneficial for the betterment of life. Sustainable investing purposes of institutional investors highlight an increasingly stronger commitment towards ESG issues. Collected data from a survey of BNP Paribas (2019) indicate that the share of asset owners and asset managers who invested at least 25% of their funds in ESG funds was equal to 48% and 53%, respectively, in 2017. Two years later, the share of asset owner and asset manager increased considerably to 72% and 62%, respectively, in 2019.
Table of Contents
- List of Figures
- List of Tables
- List of Abbreviations
- 1 INTRODUCTION
- 1.1 Background and Relevance of the Topic
- 1.2 Explanation of the Research Problem and Thesis Outline
- 2 THEORETICAL FRAMEWORK
- 2.1 Modern Portfolio Theory and Diversification
- 2.2 Diversification Measures
- 2.3 Factor Models
- 3 LITERATURE REVIEW OF ESG FUNDS CHARACTERISTICS AND FUNDS DIVERSICATION
- 3.1 History and Conceptual Definition of Responsible Investing
- 3.2 Characteristics and Development of Responsible Investing
- 3.3 Drivers and Incentives of Responsible Investing
- 3.4 Responsible Investing and Funds Value Creation
- 3.5 Responsible Investing and Funds Diversification
- 4 EMPIRICAL METHODOLOGY AND DATA
- 4.1 Methodological Approach and Hypotheses
- 4.2 Variable Explanations
- 4.3 Descriptive Statistics
- 5 EMPICIAL FINDINGS
- 5.1 CAPM and Fama-French Regressions
- 5.2 ESG Effects on Volatility, Idiosyncratic Risk, and VaR
- 5.3 Summarized Evaluation on Diversification
- 6 DISCUSSION
- 6.1 Theoretical and Practical Implications
- 6.2 Limitations and Future Research
- 7 CONCLUSION
- REFERENCES
- Appendices
Objectives & Thematic Focus
This master thesis aims to enhance the explanatory power of the limited research on fund diversification by empirically investigating the relationship between diversification effects and ESG scores of mutual funds. It seeks to provide an overview of ESG criteria for fund management and critically verify diversification effects based on Modern Portfolio Theory, ultimately challenging traditional conclusions regarding the impact of ESG on portfolio diversification.
- Impact of Environmental, Social, and Governance (ESG) factors on mutual fund diversification.
- Application and re-evaluation of Modern Portfolio Theory (MPT) in the context of responsible investing.
- Analysis of various risk measures including total risk, idiosyncratic risk, and Value-at-Risk (VaR).
- Comparison of performance and diversification benefits between ESG and conventional funds.
- Identification of investment strategies for different investor objectives (returns, risk-adjusted returns, downside risk, diversification).
- Examination of the theoretical debate surrounding diversification drawbacks in socially responsible investing.
Excerpt from the Book
1.2 Explanation of the Research Problem and Thesis Outline
The groundwork for this thesis comes from Rudd (1981), who states that the imposition of ESG factors in mutual funds may bias portfolio risk and addresses the question of diversification losses therewith. He derived his interpretation from the Modern Portfolio Theory (MPT), which states that the incorporation of sustainable holdings does imply an increase in specific risk implying that SRI funds are unable to consist of fully diver-sified portfolios.3 The loss of diversification can be attributed to the fact that a proporti-on of the investable opportunities is excluded. Moreover, the inclusion of holdings with high ESG scores increases commonalities of holdings, facilitates suboptimal cross asset correlations and subsequently increases correlation within mutual funds.
An increment in correlation is accompanied by a loss in diversification coming along with higher idio-syncratic risks. This increase in idiosyncratic risk will not be compensated by an increa-se in return (Barnett & Salomon, 2006). In short, the integration of ESG criteria into the investment process implies detriments for the portfolio diversification as it benefits sub-optimal cross asset correlations. Hoepner (2010) assesses this approach as too simpli-fied and argues against diversification detriments of mutual funds by splitting up portfo-lio diversification into three decisive components:
- the number of holdings within a portfolio,
- the correlation between the holdings' returns within a portfolio,
- the individual specific risk of holdings within a portfolio.
As initially mentioned by Rudd (1981), the first two components lead to a worsening of diversification. However, regarding the third component, Hoepner (2010) suggests that in particular mutual funds holdings with an explicit high ESG level are characterized by a specific risk being below-average. The aggregated effect of all three components does not necessarily result in an increase in portfolio diversification. Yet, it can be suggested that the overall diversification effect might not be negative and should be considered more intensively in empirical studies. Empirical findings from Bello (2005) and Verhe-yden et al. (2016) confirm that the incorporation of ESG-based holdings, in contrast to conventional holdings, support none or rather a marginal surplus in portfolio diversifi-cation.
Summary of Chapters
1 INTRODUCTION: This chapter provides background on responsible investing, highlights its increasing relevance in financial markets, and outlines the research problem concerning the diversification effects of ESG factors in mutual funds.
2 THEORETICAL FRAMEWORK: This section elaborates on Modern Portfolio Theory, detailing its principles, various measures of diversification and risk (e.g., idiosyncratic risk, VaR), and factor models like CAPM and Fama-French used for empirical analysis.
3 LITERATURE REVIEW OF ESG FUNDS CHARACTERISTICS AND FUNDS DIVERSICATION: This chapter traces the evolution of responsible investing, defines its conceptual aspects, discusses characteristics and drivers, and reviews existing literature on responsible investing's impact on fund value creation and diversification.
4 EMPIRICAL METHODOLOGY AND DATA: This section describes the methodological approach, including the formulation of hypotheses, explanation of variables (ESG scores, market cap, profitability, leverage, MTB, CO2/Total Assets, mispricing), and descriptive statistics of the mutual fund dataset used.
5 EMPICIAL FINDINGS: This chapter presents the empirical results from CAPM and Fama-French regressions, analyzes the effects of ESG scores on total risk, idiosyncratic risk, and VaR, and provides a summarized evaluation of portfolio diversification.
6 DISCUSSION: This section interprets the theoretical and practical implications of the empirical findings, addresses the limitations of the study, and suggests directions for future research in the context of ESG fund diversification.
7 CONCLUSION: This final chapter summarizes the thesis's main findings, confirming that ESG scores negatively affect idiosyncratic risk and that responsible funds can achieve non-negative portfolio diversification, with implications for investor strategies.
Keywords
ESG Funds, Responsible Investing, Mutual Funds, Diversification, Portfolio Theory, Idiosyncratic Risk, Systematic Risk, Value at Risk, Financial Performance, Sustainability, Investment Strategies, Risk Management, Capital Asset Pricing Model, Fama-French Model, Corporate Governance.
Frequently Asked Questions
What is this work generally about?
This work investigates the diversification effects of Environmental, Social, and Governance (ESG) factors in responsible mutual funds, empirically examining how ESG scores relate to portfolio risk and returns.
What are the central thematic areas?
The central thematic areas include ESG investing, portfolio diversification, Modern Portfolio Theory, various risk measures (total, idiosyncratic, VaR), and the financial performance of sustainable mutual funds.
What is the primary objective or research question?
The primary objective is to enhance the explanatory power of research on fund diversification, empirically consider the relation between diversification effects and ESG scores of mutual funds, and critically verify diversification effects based on Modern Portfolio Theory, specifically to determine if ESG funds imply a non-negative portfolio diversification effect.
Which scientific method is used?
The thesis primarily uses statistical methods, specifically multivariate Ordinary Least Squares (OLS) regressions, along with Capital Asset Pricing Model (CAPM) and Fama-French three-factor model regressions, applied to a balanced panel data set of mutual funds.
What is covered in the main part?
The main part covers the theoretical framework of portfolio diversification, a literature review of ESG fund characteristics, the empirical methodology and data, and detailed empirical findings from regressions on ESG effects on various risk measures and diversification.
Which keywords characterize the work?
Keywords characterizing the work are ESG Funds, Responsible Investing, Mutual Funds, Diversification, Portfolio Theory, Idiosyncratic Risk, Systematic Risk, Value at Risk, Financial Performance, Sustainability, Investment Strategies, Risk Management, Capital Asset Pricing Model, Fama-French Model, Corporate Governance.
What is the main debate regarding ESG criteria and portfolio diversification addressed in the thesis?
The thesis addresses the debate between Rudd (1981), who argued that ESG criteria worsen diversification due to investment restrictions, and Hoepner (2010), who challenged this by suggesting ESG funds may exhibit lower specific risk, thus leading to diversification neutrality or benefits.
How does the thesis categorize mutual funds for its analysis?
The thesis categorizes mutual funds into five quintile portfolios (Q1-Q5) based on their ESG scores, an ESG PF (funds with specific ESG-related titles), and a Difference PF (long Q5, short Q1) to enable a nuanced analysis beyond a simple ESG vs. conventional fund distinction.
Which portfolio types showed the best diversification benefits according to the study?
The study consistently found that the hybrid portfolio Q3 and the ESG PF exhibited the highest diversification benefits, characterized by the lowest idiosyncratic risk.
What are the implications for investors seeking both maximum returns and diversification?
Investors seeking maximum returns, best risk-adjusted returns, and superior diversification are advised to consider investing in funds from the ESG PF, Q3, or Q2. However, for a hedge against downside risk, Q5 and Difference PF funds are recommended.
- Arbeit zitieren
- Moritz Ernst (Autor:in), 2020, ESG Funds. Diversification of Responsible Mutual Funds, München, GRIN Verlag, https://www.grin.com/document/1334419
