Examining Inclusion of a Sustainability Criterion in Portfolio Optimization - Could an Investor Benefit from it?

Abstract: In today's society sustainability has become an important subject and has an impact on various sectors. Corporations include sustainability in their corporate strategy, which further affects the field of corporate finance. This has lead to a new insight among investors to include a sustainability criterion in their investment processes. This research has investigated how Investor AB could optimize their portfolio by including sustainability criterion (ESG) and how different portfolio setups will differ from each other.  The research has been conducted utilizing Markowitz portfolio optimization described by Markowitz theory. The application of the theory has been extended with a third criterion of a weighted ESG score rating where the optimal solutions were found using the notion of Pareto optimality and quadratic programming. Different cases have been created to find how more sustainable portfolios can differ from each other. The research shows that portfolios consisting of companies with higher ESG rating do not significantly decrease the expected return but can suffer from higher standard deviation, which indicates that it is driven by assets with higher ESG score rating. The obtained results show that the portfolios obtained including the third criterion will not always obtain a value of Jensen's Alpha above zero (0) and are therefore not optimal strategies to outperform the benchmark index, SIX Return Index. A portfolio that consists of non-sustainable and sustainable assets has performed better than other portfolios that under- or overperform from the perspective of sustainability.  The conclusion is that an investor must sacrifice a higher weighted ESG score rating of its portfolio to obtain a higher expected return and less risk. An investor that aims for higher return, must exclude the sustainability criterion.