Morningstar - Q2 2021 - 49

return. Similarly, under both views, the
ESG-negative stock has the same standard
deviation but a lower expected return. Taking
all possible portfolio combinations of the two
stocks (both long and short positions) under
the ESG-unaware view results in the ESG-unaware
frontier (which is not the true frontier, as
it fails to incorporate pecuniary ESG factors).
Similarly, taking all possible portfolio combinations
of the two stocks under the ESG-aware view
results in the ESG-aware frontier (which
is the true frontier, as it correctly incorporates
pecuniary ESG factors). Note how the ESG-aware
frontier is higher and wider than the ESGunaware frontier.
As in the standard CAPM, each investor holds
a portfolio on a line that is tangent to his or
her estimated frontier, emanating from the point
that represents the risk-free asset (cash). Each
of these portfolios is mean-variance-efficient
under the respective investor's view. As E X H I BI T 1
shows, in the model that I present here, the
frontiers under both views have the same tangent
line. However, the portfolio represented by
each point on the line depends on which view
is in effect. In fact, the portfolios of both
investors are on the same point, even though,
as EX H IB IT 2 shows, their compositions
are different.
Interestingly, the market portfolio has the same
expected return and standard deviation
under both views. However, because it is below
the tangent line, it is not mean-variance-efficient
under either view.
provides the details on the portfolios
shown in E X H I B I T 1 . Under the ESG-unaware
view, the tangent portfolio is about 66% in the
ESG-negative stock. The investor with the
ESG-unaware view holds a leveraged position
of this tangent portfolio, going short about
19% in cash.
EXHIBIT 2

In contrast, under the ESG-aware view, the
tangent portfolio is about 72% in the ESG-positive

stock. The investor with the ESG-aware view
combines this tangent portfolio with about
a 19% long position in cash, which offsets the
short position in cash of the other investor.

Different ESG Views and Nonpecuniary
Preferences
To introduce nonpecuniary preferences
into the model, I now assume that
there are four investors, all with the same level
of capital: 10

In E X H IB IT 2 , I have included the Sharpe ratios
of each portfolio under the ESG-aware view.9
The Sharpe ratio measures the mean-variance
efficiency of a portfolio. Under the ESG-aware
view (correct view), only the ESG-aware investor
holds a mean-variance-efficient portfolio.
The ESG-unaware investor inadvertently holds
an inefficient portfolio. Because the market
portfolio is a blend of efficient and inefficient
portfolios, it is inefficient.

gNo. 1 holds the ESG-unaware view and has
no nonpecuniary ESG preference.
gNo. 2 holds the ESG-unaware view and has
a nonpecuniary ESG preference.
gNo. 3 holds the ESG-aware view and has
no nonpecuniary ESG preference.
gNo. 4 holds the ESG-aware view and has
a nonpecuniary ESG preference.

EXHIBIT 1

Equilibrium With Different ESG Views and No Nonpecuniary Preferences
Expected Return
10%

TA N

N
GE

INE

9
8

Tangent Portfolio

ESG-Positive Stock

Investor Portfolios
Tangent Portfolio

Market Portfolio

5
4

ESG-Negative Stock

ESG-U

ESG

Risk-Free Asset

0%
5
Standard Deviation

- AW

N AWA

RE FR
ON

TIER

2
AR

IER

0
20

Source: Morningstar.

9 The Sharpe ratio of a portfolio is ( - rf ) / , where µ is the expected return of the portfolio, rf is the risk-free rate, and is the standard deviation of return on the portfolio.
10 The PFP model has three types of investors who are like investors No. 1, No. 3, and No. 4. They do not include No. 2.

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