How the theory of the ESG-efficient frontier will impact ESG-investing in the future

This week, the FT published an article about how BlackRock is highlighting the changing role of sustainable investments. They claim that “investors have been warned of the need to prepare for a potentially drastic repricing of assets as huge sums of money flowing into sustainable investment products threaten to upend traditional pricing models”. According to analysts at BlackRock, markets do not value sustainability properly and, as investors shift more and more money into sustainable funds, companies that perform well on environmental, social and governance criteria should gradually increase in value and those that do not should fall. “This tectonic shift has significant implications for the expected returns and relative pricing of assets — not just those perceived to be sustainable but for every asset in the investment universe,” BlackRock writes in the report. This statement is striking as it flies in the face of conventional wisdom on sustainable investing. While it has since been assumed that sustainable funds face a return trade-off because the benefits of sustainability are already priced into asset, the biggest asset manager in the world now argues that the opposite is true. It is a new phenomenon for investors to prioritize sustainability so the value will not be visible in historical data. In their report, BlackRock further suggests that “markets are a long way from fully pricing in the far-reaching consequences of changing attitudes toward sustainability . . . [because] structural shifts are typically under-appreciated for long periods of time by financial markets — as has been the case for demographic shifts such as the baby boom.” The trigger to this pricing shift would be the large amount of money invested in sustainable companies. “Society will care much more about sustainability in the future than it has in the past,” BlackRock said.

In this article, we examine the most recent research theories that back up this statement because the big questions arising from BlackRock’s statements is: how do you really do it? How do you incorporate ESG into your investment views and does it really raise your returns or does it lower your returns? We have seen that it’s a very heavily debated issue at the moment: some people may say that apparently, ESG must necessarily raise returns because investing in good firms must be a good investment,” while other people claim that it must necessarily lower returns because it’s an extra constraint and constraints lower returns.

With the spike in global ESG investment volume comes a new underlying portfolio theory

A first answer to this investor problem is to see it through the so called ESG-efficient frontier which will be a more and more useful tool considering portfolio decision making. There are theories about why certain measures of ESG may in fact be associated with higher returns while other measures are associated with lower returns. The answer lies in the combination of theories of investor avoidance leading to lower prices by Merton (1987), tastebased discrimination by Becker (1957) and statistical discrimination by Phelps (1972).

The theories from Merton and Becker helped to conclude that ESG plays two crucial roles for investors. Firstly, it is informative about what kind of company the company or stock you are talking about, e.g. whether it is wasteful, well governed etc. and thereby providing the investor with indications about future profits. Secondly, ESG also affects the investor preference as separate from profits as suggested through a link to an old theory of Becker called the “tastebased” discrimination with the idea that some stocks with good ESG preferences are preferred to those with bad preferences. At the same time link to theory of statistical discrimination which says: different social groups have different properties, so, even if youre not having a taste against low ESG-stocks you will update your beliefs on stock preferences. These findings led a group of researchers to come up with an updated set of assumptions about today’s investor characteristics which results in the new theory about the ESG-efficient frontier. What is new today when we’re looking at assets, is that, in addition to the risk free-rate and the number of risky assets, we now have ESG scores for every asset. Therefore, they distinguish three new different types of investors. Firstly, the ESG-unaware investors who completely ignore ESG information and thus compute risk and expected return without regard to ESG and just optimize their risk adjusted return. Secondly, they identify ESG-aware investors who actually take into account that the ESG score can be informative about the risk and return as in that e.g. a well governed firm might generate higher returns or have a different risk profile. Once they’ve made that judgement, they perform the normal investor optimization and maximize their risk-adjusted return. Thirdly, and this
is what changes everything, there will be ESG-motivated investors who use ESG information but also have preference for higher ESG stocks as separate from risk and return.

The new ESG-adjusted efficient frontier from an investor’s perspective

Emanating from Markowitz’ classic theory of explaining the standard-mean-variance efficient frontier – according to which investors only care about risk and expected return and therefore always choose a combination of the tangency portfolio and the risk free asset to maximize their Sharpe Ratio – the newest research by Pedersen, Fitzgibbons and Pomorski rightly suggests that, in addition to risk and return, investors also care about the ESG score. To put it simply, the new model squeezes these three dimensions into a two-dimensional model, plotting the Sharpe Ratio over a theoretical ESG score ranging from zero to one, with 0 being a worst offender and 1 being the most sustainable firm. The resulting ESG-adjusted efficient frontier explains the portfolio choices of the three different types of investors and provides a far better implication in a time when investors gradually transition from being ESG-unaware to being ESG-motivated. While the peak of the resulting curve represents a tangency portfolio that includes ESG information and therefore maximizes the Sharpe Ratio, the model assumes that the ESG-efficient frontier to the right-hand side of the peak symbolizes the inherent tradeoff investors face when they invest in high ESG stocks. The new model will better explain how investor preferences will drive future portfolio decisions. ESG-unaware investors ignoring ESG information will use the classical tangency portfolio. This portfolio is no longer maximizing Sharpe Ratio since these investors use
suboptimal measures of expected return and suboptimal measures of risk. In contrast, ESGaware investors leveraging on ESG information without having a separate preference for ESG stocks per sé, but simply maximizing returns instead, will pick the tangency portfolio at the top. In turn, the ESG-motivated investors who genuinely care about ESG for other purposes than pure profit maximization will put themselves to the right of the curve.

Admittedly, the entire model certainly relies to a certain extent on the question of how informative ESG information is and will be in future. Essentially, the more informative ESG scores are, the bigger will the difference in Sharpe Ratio between the classical tangency portfolio and the tangency portfolio using ESG information be.

What the newest empirical studies unveil about the potential costs and benefits of ESG information

As part of their research paper, Pedersen, Fitzgibbons and Pomorski furthermore gathered data that coincide with the theories and the underlying assumptions of it. They observed investors over a substantial period of time and derived investment decisions that each type of ESG-investor would have made under the given assumptions. The correspondence is striking. The modeling of the realized ESG-Sharpe ratio frontiers replicates the theory. For the first time, it quantifies the potential costs and benefits of incorporating ESG-information into investment decisions. The differences are highlighted as percentages of Sharpe Ratio – the one thing investors most often have in mind. While the benefits as measured by the difference in Sharpe Ratio between the “ESG including tangency portfolio” (A) and the “ESG excluding tangency portfolio” (U) rates at 12%, they clearly exceed costs because ESG-motivated investors (M) are ready to give up 4% on Sharpe Ratio in return for a doubling of the ESG score.

The practical implications of the new ESG-efficient frontier regarding ESG integration for investors

Apparently, investors will no longer consider the classical 2-fund separation of tangency portfolio and risk-free asset – the old Markowitz solution of the classical theory – but, under the previously mentioned assumptions, it is now evolving into a 4-fund separation. According to this, every investor should buy some combination of four portfolios including the conventional tangencyportfolio, the risk-free portfolio, the minimum-variance-portfolio and the ESG-tangency-portfolio.

These findings can be interpreted as the theoretical foundation of ESG integration. In general, if we assume the investors perspective, the new ESG-efficient frontier will help investors with finding
their favorite measure of ESG when making a decision on where they want to be on the ESGefficient frontier. In fact, you could describe it with the “ESG-appetite” which adds to the growing list of sustainable finance jargon.

What about the overarching question whether buying high ESG stocks lowers or raises returns?

Several theories are claiming that ESG has positive effects on profits and it has consequently become something like a general assumption. However, profits are not synonymous with returns. Returns are always a contingency of the profits of a stock you buy and the price you pay in order to get the profits in question. The empirical findings from Pedersen et al. have revealed that, when modelling expected excess returns over ESG scores, the results differ between the characteristics of the investor majorities. It is for this reason that the CAPM must be ESG-adjusted. According to the new theory, expected excess returns for companies differ with regard to three distinct market scenarios. In the first case the market is dominated by ESG-unaware investors, hence, stock prices remain unaffected because the benefits of ESG are not incorporated into stock prices. As a direct consequence of this, better ESG firms which are more profitable and therefore deliver higher returns due to an unaffected stock price. The outcome is an upward sloping expected excess return curve. In contrast, when the market is dominated by ESG-aware investors, good ESG seems to be correlated with profits, the price of the stock will bid up to reflect the future higher profits. As a consequence of this, future expected excess returns have no link to ESG scores and therefore remain a flat line. Ultimately, in the last scenario where the market is dominated by ESG-motivated investors, stock prices for ESG stocks will not only bid up because they are more profitable but even further because of a high demand for these stocks. Hence, stock prices will increase due to this high demand and future returns will decrease. The expected excess return is a downward sloping curve.

This implies that, if we tend to transition from ESG-unaware investors to ESG-motivated investors in the long run, our CAPM assumptions will need to be reevaluated. Apparently, “good” ESG stocks will deliver lower returns. If the fundamental assumption of homogeneous expectations among investors will have to be replaced by something new that incorporates ESG consciousness along with profit maximization, the CAPM theory of efficient markets will not hold any longer and investments in “good” ESG firms will be deemed as a constraint.


There are several research papers suggesting that ESG incorporation into portfolio decisions will have to be performed sophisticatedly and relying on historic theories will probably turn out to be a pitfall. The costs and benefits of ESG-investing are visible and quantifiable for the first time when applying the updated model of the ESG-efficient frontier. For sure, more precise and comprehensive data gathering will be needed to prove that all underlying assumptions hold true. It remains to be seen how well ESG scores really reflect a firm’s sustainability and profit outlook. Quantifying ESG scores is subject to confounding factors such as “greenwashing” practices that cannot be exposed in the short-term. As a matter of fact, the theories have shown how well ESG relates to expected returns, showing that when investors will not take ESG information into account, returns will be higher, while the opposite of investors taking them into account will result in lower returns.

Authors: Oumaima Saidouk, Lukas Rombach, Edoardo Castangia

Billy Nauman: “BlackRock highlights changing role of sustainable investments”; Financial Times, February 28 2020
Pedersen, Lasse Heje and Fitzgibbons, Shaun and Pomorski, Lukasz, “Responsible Investing: The ESG-Efficient Frontier” (October 1, 2019). Available at SSRN: or
Pastor, Lubos and Stambaugh, Robert F. and Taylor, Lucian A., “Sustainable Investing in Equilibrium” (February 14, 2020). Available at SSRN: or
Hong, Kacperczyk: “The price of sin: the effects of social norms on markets”, Journal of Financial Economics (April 2009). Available at:
Cao, Titman, Zhan, Zhang: “ESG Preference and Market Efficiency: Evidence from mispricing and institutional trading” (October 2018). Available at:
RBC Global Asset Management: “ESG and Market Inefficiency” (November 2018). Available at:


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