Corporate Social Responsibility and Investment Portfolio Diversification

Andrew Rudd's inescapable conclusion that the integration of environment, social or governance (ESG) criteria in investment processes must worsen portfolio diversification appears to be academic wisdom since nearly thirty years, but is it right? We argue that it is wrong. We develop a simple theoretical model based on the three main drivers of portfolio diversification ((1) number of stocks, (2) correlation of stocks, (3) average specific risk of stocks) and recent robust evidence on the significantly negative relationship between a firm's ESG rating and its specific risk. Our theory argues that while the inclusion of ESG criteria into investment processes likely worsens portfolio diversification via the first and second driver, it similarly likely improves portfolio diversification through a reduction of the average stock's specific risk. This positive effect of ESG criteria probably leads best-in-class ESG screened funds to be better diversified than otherwise identical conventional funds. With our simple theory, we aim to open a debate on the question, if (and when) the inclusion of ESG criteria into investment portfolios really worsens their diversification. Our theory implies that mainstream active investment managers appear well advised to consider the inclusion of ESG criteria in their portfolio management process to optimise their risk management. Especially pension funds should at least contemplate about the use of ESG criteria, as an ignorance of ESG criteria could violate their fiduciary risk management duties