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When trackers are aware of ESG: Do ESG ratings matter to tracking error portfolio performance?

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  • Ling, Aifan
  • Li, Junxue
  • Wen, Limin
  • Zhang, Yi

Abstract

With the increasing severity of the greenhouse effect and environmental pollution, environmental, social, and governance (ESG) investing has received much attention in recent years. This paper studies how ESG scores and investors’ ESG preferences affect the performance of tracking portfolios. We embed ESG information and the ESG preferences of investors into the mean–variance tracking error model, and then explicitly solve the new tracking portfolio model. The theoretical analysis shows that ESG information can improve the expected returns, information ratio (IR) and other performance metrics of tracking portfolios. The relationship between the ESG scores and IR of tracking portfolios is represented by an inverse U-type ESG-IR frontier. Consistent with theoretical predictions, numerical results with a real market benchmark show that ESG information and ESG investor preference have a positive impact on the realized returns, IR, net aggregate returns and cumulative returns of tracking portfolios. Our results provide investors with several valuable references about ESG awareness and preferences.

Suggested Citation

  • Ling, Aifan & Li, Junxue & Wen, Limin & Zhang, Yi, 2023. "When trackers are aware of ESG: Do ESG ratings matter to tracking error portfolio performance?," Economic Modelling, Elsevier, vol. 125(C).
    • Handle: RePEc:eee:ecmode:v:125:y:2023:i:c:s026499932300158x
    DOI: 10.1016/j.econmod.2023.106346
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    Cited by:

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    2. Luo, Deqing & Shan, Xun & Yan, Jingzhou & Yan, Qianhui, 2023. "Sustainable investment under ESG volatility and ambiguity," Economic Modelling, Elsevier, vol. 128(C).

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    More about this item

    Keywords

    ESG-IR frontier; ESG investing; Tracking error portfolio; Information ratio; Mean–variance model;
    All these keywords.

    JEL classification:

    • C63 - Mathematical and Quantitative Methods - - Mathematical Methods; Programming Models; Mathematical and Simulation Modeling - - - Computational Techniques
    • D62 - Microeconomics - - Welfare Economics - - - Externalities
    • G11 - Financial Economics - - General Financial Markets - - - Portfolio Choice; Investment Decisions
    • G12 - Financial Economics - - General Financial Markets - - - Asset Pricing; Trading Volume; Bond Interest Rates
    • G14 - Financial Economics - - General Financial Markets - - - Information and Market Efficiency; Event Studies; Insider Trading
    • G23 - Financial Economics - - Financial Institutions and Services - - - Non-bank Financial Institutions; Financial Instruments; Institutional Investors
    • G34 - Financial Economics - - Corporate Finance and Governance - - - Mergers; Acquisitions; Restructuring; Corporate Governance
    • G4 - Financial Economics - - Behavioral Finance

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