Warning: SRI Need Not Kill Your Sharpe and Information Ratios-Forecasting of Earnings and Efficient SRI and ESG Portfolios

Abstract

Using an earnings forecasting model is useful and produces statistically significant outperformance in US stock selection. This study finds that the incorporation of environmental, social, and governance (ESG) criteria can potentially enhance stockholder returns, holding risk constant under reasonable assumptions. The novel approach here uses a normalization of ESG strengths and weaknesses ratings, applied in both robust simply-weighted and realistic optimized portfolio settings. The study confirms a now-classical no-cost result for the overall ESG criteria and—with Human rights and Corporate Governance criteria—shows that SRI and ESG information can enhance portfolio returns in certain implementations. Thus, SRI and ESG investors may not necessarily have to expect lower portfolio returns and Sharpe ratios under all circumstances.

TOPICS: ESG investing, portfolio theory, portfolio construction, performance measurement

Key Findings

• • ESG measures can be used in conjunction with a statistically significant earnings forecasting efficiency tilt so that portfolio standard deviation and tracking errors decrease.

• • Decreased portfolio standard deviation and tracking error increase portfolio Sharpe and information ratios. Return-to-risk ratios rise with KLD SRI and ESG variables.

• • The incorporation of KLD human rights factors, including those related to indigenous peoples, and the inclusion of overall KLD concerns increase Sharpe ratios and information ratios. No longer are researchers merely concerned with asking, “Is there a cost to being socially responsible in investing?” across the board.