Responsible Investing: Costs and Benefits. A Cross-Country Study in Europe.
Abstract: This study employs the ESG-Sharpe Ratio frontiers framework and the ESG-adjusted CAPM model, introduced by Pedersen et al. (2020), to identify the costs and benefits of responsible investing and investigate the relationship between the environmental, social, and governance (ESG) issues and portfolio performance in different countries across Europe. In this paper, we explain the cross-country differences in the empirical results to draw a better picture of ESG integration for responsible investors. Our cross-country comparison of the ESG-SR frontiers shows that the investors pay a higher cost for being ESG-motivated in the United Kingdom and Sweden than other countries and regions. In other words, for choosing a portfolio with the same ESG characteristics, ESG-motivated investors would sacrifice a higher percentage of their Sharpe Ratio in the United Kingdom and Sweden. These frontiers also reveal that ESG-aware investors earn a maximum ex-ante Sharpe Ratio higher than that of the ESG-unaware investors or equal to it, in all countries and regions, indicating that using the ESG information in the portfolio selection process can benefit the investors, even when they do not care about ESG issues. Moreover, we construct a mimicking portfolio for ESG factor to analyse the relationship between stocks' ESG scores and their expected returns. The estimated alphas obtained from asset pricing models show that ESG scores predict future returns positively only in Switzerland, and negatively in the United Kingdom, France, and the Europe region. Further, we show that these perceived alphas can be explained by the ESG-adjusted CAPM model for all countries and regions, except for the Netherlands.
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