Including ESG concerns in the portfolio selection process : An MCDM approach

University essay from KTH/Optimeringslära och systemteori; KTH/Optimeringslära och systemteori

Author: Edvin Lundström; Carl Svensson; [2014]

Keywords: ;

Abstract:

In recent years investors in the financial markets around the globe have begun to focus on non-financial factors in their portfolio selection processes. Three main areas of concerns are: Environmental, Social and corporate Governance (ESG). Previous research has mainly focused on implementing these concerns using qualitative methods, e.g. negative screening. Our thesis integrates these concerns in a Multi-Criteria Decision-Making (MCDM) framework, making it possible for investors to view the portfolio selection as a trade-o_ between three criteria: Return, Risk and ESG. This extends the traditional Markowitz frontier from two to three dimensions. Companies included are the ones in the index OMXS30. Return and risk are estimated using the single-index model. The ESG criterion is implemented as a linear function and estimated using two public ESG indices.

We will use two different optimization methods, the weighted sum approach and the "-constraint method to compute the efficient frontier. These are evaluated and we conclude that each method has its own strengths and weaknesses. We can see that integrating ESG concerns as a third objective in addition to risk and return alters the portfolio selection process. It increases the complexity of choosing a portfolio, but also yielding a better decision basis for the investor. To mitigate the increase of complexity we propose the ESG-to-variability ratio in analogy with the Sharpe ratio, effectively reducing the number of portfolios an investor should consider.

 

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