Morningstar - Q2 2021 - 50

Strategies

EXHIBIT 2

Details of Portfolios Under Equilibrium With Different ESG Views and
No Nonpecuniary Preferences

gives the highest possible value of riskadjusted expected return for a given level of
nonpecuniary ESG exposure.11

Cash (%)

Expected
Return (%)

Standard
Deviation (%)

Sharpe
Ratio under
ESG-Aware
View

0.23

Portfolio Weights
ESG Pos.
Stock (%)

ESG Neg.
Stock (%)

View

Portfolio

ESG-Unaware

Tangent

34.36

65.64

0.00

4.86

10.96

Investor

40.88

78.09

-18.96

5.40

13.04

Tangent

71.59

28.41

0.00

6.19

16.09

Investor

58.01

23.03

18.96

5.40

13.04

Market

49.44

50.56

0.00

5.21

12.67

ESG-Aware

Both

0.26

0.25

Source: Morningstar.

EXHIBIT 3

Pecuniary/Nonpecuniary ESG Frontier and Investor Decisions
Nonpecuniary ESG Exposure
IN

ESG

- AW

ARE

FRO

100%
FF

NTI

80
E

As this exhibit shows, investors who have no
nonpecuniary preferences (Investor No. 3) select
whatever level of nonpecuniary ESG exposure
goes with the portfolio with the highest level of
risk-adjusted expected return. In contrast,
investors with nonpecuniary preferences (Investor
No. 4) give up some risk-adjusted expected return
to gain some nonpecuniary ESG exposure.
To what extent they make this trade-off depends
on (1) the curvature of the frontier and (2)
the strength of their nonpecuniary preferences.
In EXHIB IT 3 , I have included an indifference
curve, which is a line that is tangent to pecuniary/
nonpecuniary frontier.12 The slope of this line
shows how much risk-adjusted expected
return the investor is willing the give up to gain
nonpecuniary ESG exposure, based on his
or her nonpecuniary preferences. The point of
tangency with the frontier shows where the
investor ends up.
EXHIB IT 4 shows investor portfolios under three
sets of assumptions:

Investor With Nonpecuniary Preferences
20

Investor Without Nonpecuniary Preferences
1.5%
2.0
2.5
Risk-Adjusted Expected Return

3.0

0
3.5

4.0

4.5

1 Investors have ESG-unaware views and
no nonpecuniary preferences.
2 Investors have different ESG views and
no nonpecuniary preferences.
3 Investors have different ESG views and
nonpecuniary preferences.

Source: Morningstar.

There can be trade-offs between nonpecuniary
ESG and pecuniary risk-adjusted
expected return. Investors who have no
nonpecuniary preferences seek to maximize
risk-adjusted expected return, while those
with pecuniary preferences seek to balance

nonpecuniary ESG exposure and risk-adjusted
expected return.
E X H I BI T 3 illustrates how this works. Based on
the ESG-aware view, it shows the pecuniary/
nonpecuniary frontier. Each point on this frontier

The first set of assumptions gives us the CAPM
with identical investors. The result is that
all investors hold the market portfolio, which here
is about 50% in the ESG-positive stock and
50% in the ESG-negative stock. The second set of
assumptions is the model that I presented
in EXHIB IT S 1 and 2 . I have included it here to
contrast it with the other models. The third
set of assumptions is the model with four investors.

11 PFP present a similar frontier but use the Sharpe ratio rather than risk-adjusted expected return as the pecuniary measure.
12 An indifference curve shows combinations of two quantities, which the investor is indifferent to holding. If the two quantities are both desirable to the investor, the further up and to the right
an indifference curve is, the more desirable the combinations it represents. Because the frontier gives the highest feasible combinations, the indifference curve that is tangent to the frontier,
at the point of tangency, gives the combination that the investor holds.

Morningstar Q2 2021

Morningstar - Q2 2021

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