Optimal ESG portfolios: an example for the Dow Jones Index

Abstract

Mean variance portfolio theory is expanded to accommodate investors’ preferences for the portfolio ESG value (PESGV). Namely, PESGV is added to the minimizing objective function so that portfolio weights are simultaneously optimized in terms of returns, risk (volatility), and PESGV. PESGV is assumed proportional to the sum of portfolio constituents’ weighted ESG scores and is controlled by the ESG strength parameter γ. A new ESG portfolio performance measure, the ESG tilted Sharpe ratio, is introduced. Its maximum can be used for determining γ. A portfolio formed with 29 constituents of the Dow Jones Index in 2015–2019 is considered as an example. The MSCI ESG ratings are chosen for estimating PESGV. It is found that higher PESGVs yield more concentrated portfolios and lower Sharpe ratios. Partial correlations based portfolios are more diversified and have higher PESGVs than the Pearson’s correlations based portfolios.