ESG Funds. Diversification of Responsible Mutual Funds

Table of Contents

• List of Figures
• List of Tables
• List of Abbreviations
• 1 INTRODUCTION
  • 1.1 Background and Relevance of the Topic
  • 1.2 Explanation of the Research Problem and Thesis Outline
• 2 THEORETICAL FRAMEWORK
  • 2.1 Modern Portfolio Theory and Diversification
  • 2.2 Diversification Measures
  • 2.3 Factor Models
• 3 LITERATURE REVIEW OF ESG FUNDS CHARACTERISTICS AND FUNDS DIVERSICATION
  • 3.1 History and Conceptual Definition of Responsible Investing
  • 3.2 Characteristics and Development of Responsible Investing
  • 3.3 Drivers and Incentives of Responsible Investing
  • 3.4 Responsible Investing and Funds Value Creation
  • 3.5 Responsible Investing and Funds Diversification
• 4 EMPIRICAL METHODOLOGY AND DATA
  • 4.1 Methodological Approach and Hypotheses
  • 4.2 Variable Explanations
  • 4.3 Descriptive Statistics
• 5 EMPICIAL FINDINGS
  • 5.1 CAPM and Fama-French Regressions
  • 5.2 ESG Effects on Volatility, Idiosyncratic Risk, and VaR
  • 5.3 Summarized Evaluation on Diversification
• 6 DISCUSSION
  • 6.1 Theoretical and Practical Implications
  • 6.2 Limitations and Future Research
• 7 CONCLUSION
• REFERENCES
• Appendices

Objectives & Thematic Focus

This master thesis aims to enhance the explanatory power of the limited research on fund diversification by empirically investigating the relationship between diversification effects and ESG scores of mutual funds. It seeks to provide an overview of ESG criteria for fund management and critically verify diversification effects based on Modern Portfolio Theory, ultimately challenging traditional conclusions regarding the impact of ESG on portfolio diversification.

• Impact of Environmental, Social, and Governance (ESG) factors on mutual fund diversification.
• Application and re-evaluation of Modern Portfolio Theory (MPT) in the context of responsible investing.
• Analysis of various risk measures including total risk, idiosyncratic risk, and Value-at-Risk (VaR).
• Comparison of performance and diversification benefits between ESG and conventional funds.
• Identification of investment strategies for different investor objectives (returns, risk-adjusted returns, downside risk, diversification).
• Examination of the theoretical debate surrounding diversification drawbacks in socially responsible investing.

Excerpt from the Book

Summary of Chapters

1 INTRODUCTION: This chapter provides background on responsible investing, highlights its increasing relevance in financial markets, and outlines the research problem concerning the diversification effects of ESG factors in mutual funds.

2 THEORETICAL FRAMEWORK: This section elaborates on Modern Portfolio Theory, detailing its principles, various measures of diversification and risk (e.g., idiosyncratic risk, VaR), and factor models like CAPM and Fama-French used for empirical analysis.

3 LITERATURE REVIEW OF ESG FUNDS CHARACTERISTICS AND FUNDS DIVERSICATION: This chapter traces the evolution of responsible investing, defines its conceptual aspects, discusses characteristics and drivers, and reviews existing literature on responsible investing's impact on fund value creation and diversification.

4 EMPIRICAL METHODOLOGY AND DATA: This section describes the methodological approach, including the formulation of hypotheses, explanation of variables (ESG scores, market cap, profitability, leverage, MTB, CO2/Total Assets, mispricing), and descriptive statistics of the mutual fund dataset used.

5 EMPICIAL FINDINGS: This chapter presents the empirical results from CAPM and Fama-French regressions, analyzes the effects of ESG scores on total risk, idiosyncratic risk, and VaR, and provides a summarized evaluation of portfolio diversification.

6 DISCUSSION: This section interprets the theoretical and practical implications of the empirical findings, addresses the limitations of the study, and suggests directions for future research in the context of ESG fund diversification.

7 CONCLUSION: This final chapter summarizes the thesis's main findings, confirming that ESG scores negatively affect idiosyncratic risk and that responsible funds can achieve non-negative portfolio diversification, with implications for investor strategies.

Keywords

ESG Funds, Responsible Investing, Mutual Funds, Diversification, Portfolio Theory, Idiosyncratic Risk, Systematic Risk, Value at Risk, Financial Performance, Sustainability, Investment Strategies, Risk Management, Capital Asset Pricing Model, Fama-French Model, Corporate Governance.

Frequently Asked Questions

What is this work generally about?

This work investigates the diversification effects of Environmental, Social, and Governance (ESG) factors in responsible mutual funds, empirically examining how ESG scores relate to portfolio risk and returns.

What are the central thematic areas?

The central thematic areas include ESG investing, portfolio diversification, Modern Portfolio Theory, various risk measures (total, idiosyncratic, VaR), and the financial performance of sustainable mutual funds.

What is the primary objective or research question?

The primary objective is to enhance the explanatory power of research on fund diversification, empirically consider the relation between diversification effects and ESG scores of mutual funds, and critically verify diversification effects based on Modern Portfolio Theory, specifically to determine if ESG funds imply a non-negative portfolio diversification effect.

Which scientific method is used?

The thesis primarily uses statistical methods, specifically multivariate Ordinary Least Squares (OLS) regressions, along with Capital Asset Pricing Model (CAPM) and Fama-French three-factor model regressions, applied to a balanced panel data set of mutual funds.

What is covered in the main part?

The main part covers the theoretical framework of portfolio diversification, a literature review of ESG fund characteristics, the empirical methodology and data, and detailed empirical findings from regressions on ESG effects on various risk measures and diversification.

Which keywords characterize the work?

Keywords characterizing the work are ESG Funds, Responsible Investing, Mutual Funds, Diversification, Portfolio Theory, Idiosyncratic Risk, Systematic Risk, Value at Risk, Financial Performance, Sustainability, Investment Strategies, Risk Management, Capital Asset Pricing Model, Fama-French Model, Corporate Governance.

What is the main debate regarding ESG criteria and portfolio diversification addressed in the thesis?

The thesis addresses the debate between Rudd (1981), who argued that ESG criteria worsen diversification due to investment restrictions, and Hoepner (2010), who challenged this by suggesting ESG funds may exhibit lower specific risk, thus leading to diversification neutrality or benefits.

How does the thesis categorize mutual funds for its analysis?

The thesis categorizes mutual funds into five quintile portfolios (Q1-Q5) based on their ESG scores, an ESG PF (funds with specific ESG-related titles), and a Difference PF (long Q5, short Q1) to enable a nuanced analysis beyond a simple ESG vs. conventional fund distinction.

Which portfolio types showed the best diversification benefits according to the study?

The study consistently found that the hybrid portfolio Q3 and the ESG PF exhibited the highest diversification benefits, characterized by the lowest idiosyncratic risk.

What are the implications for investors seeking both maximum returns and diversification?

Investors seeking maximum returns, best risk-adjusted returns, and superior diversification are advised to consider investing in funds from the ESG PF, Q3, or Q2. However, for a hedge against downside risk, Q5 and Difference PF funds are recommended.