In 1981, Andrew Rudd introduced a notion that the integration of economic, social or governance (ESG) criteria in the investment process must irrefutably worsen portfolio diversification. In this paper Andreas Hoepner explores this notion by developing a simple theoretical model based on three main drivers of portfolio diversification which are:

1. Number of stocks
2. Weighted average correlation of stocks
3. Weighted average specific risks of stocks

Hoepner argues, while the inclusion of ESG criteria into investment processes likely worsen portfolio diversification through the first and second driver, it improves diversification through a reduction of average stock’s specific risks.

Hoepner’s theory is based on two robust notions which are founded on recent, unchallenged empirical findings that stocks with high ESG rating have, everything else equal, a lower risk than otherwise identical stocks of lower ESG rating and the same systematic risk. The other notion is based on the mathematics and formula of diversification which include both variance and covariance terms.

The empirical findings are that the relationship between ESG rating and firm specific risk to date have a statistically significant relationship. The relationship is that a stock’s ESG rating is negatively related to its specific risk. This implies that highly ESG rated stocks have a lower total risk compared to identical stocks with low ESG rating.

Hoepner thoroughly explores the theory using formulas and methodologies developed by Markowitz in 1952 and Statman in 2004.

Hoepner, continues to argue that if two portfolios are identically exposed to drivers one and two above, then the portfolio with on average better ESG rating will have lower total risk, lower specific risk and hence better diversification, ceteris paribus. However, as portfolios become larger and become diversified over several thousand assets, the advantages of additional diversification through higher ESG rating becomes increasingly redundant.

The paper concludes with Hoepner summarising his key findings and reinstates his theory to be in direct opposition to Andrew Rudd’s initial conclusion in 1981. Hoepner provides a few implications of his theory, that active investment managers appear to be well advised to consider ESG criteria in their portfolio management, pension funds should be contemplating the use of ESG criteria, and he encourages academic researchers of ESG investment to challenge Rudd’s simple theoretical model. Hoepner also includes a few insights of how mutual funds can integrate ESG criteria in their investment process by either improving mandatory reporting on ESG issues and requiring sovereign wealth funds or government pension funds to so they can reap the benefits of portfolio diversification.

1. Hoepner includes an interesting analogy in his paper where he compares stocks to eggs. Intuitively, people would not have holes or poor quality baskets carrying eggs. This is like financial markets with the exception that investors tend to overlook the hole in the basket before the eggs have fallen and value is lost. Hoepner concludes that investors or asset managers are diversifying their portfolios in irresponsible risks which have low economic, social or governance (ESG) ratings and high ESG risks. These factors make the basket of stocks ‘low quality’ and thus begin to lose value and have lower returns.
2. In discussing the mathematics on the three components which determine portfolio diversification, Statman in 2004, states that a portfolio standard deviation decreases degressively with its number of stocks. This is due to the fact that the aggregated impact of variances becomes inconsequentially small once a portfolio is invested in a sufficient number of stocks.
3. The correlation between the selected assets is determined by the amount of assets in a portfolio that are correlated with each other. If the correlation factor is small, the smaller is the standard deviation of the portfolio.
4. The standard deviation of the selected assets is commonly overlooked as a driver of portfolio diversification. When including this driver in your portfolio diversification equation, it is important to distinguish between two types. While the proportion of average standard deviation resulting from an asset’s systematic risk is compensated by financial markets, the other proportion of average standard deviation from specific risk is uncompensated.
5. Corporations that include ESG actions that are directed towards society, provides the opportunity for firms to build up an insurance similar to goodwill. These actions may protect firms from overly negative market reactions in instances of public legal or regulatory action against them.
6. Hoepner argues that if two portfolios are identically exposed to the diversification drivers of 'number of selected assets' and 'correlation between selected assets', then the portfolio with the on average better ESG rating will have lower total and specific risk leading to better diversification. He reinstates his point by suggesting that mutual funds, pension funds or sovereign wealth funds who adopt a best-in class responsible investment strategy will improve their portfolio diversification.
7. Hoepner recommends that pension funds should contemplate the use of ESG criteria in their investment endeavours. He believes that an ignorance of ESG violates their fiduciary risk management policies. Further, he suggests that policy makers in these firms should strengthen their support of ESG criteria in financial markets as they can decrease the ESG risk and financial risk of investment portfolios
8. Hoepner actively encourages academic researchers of ESG investment to challenge his theory and Rudd’s initial theory, as he believes that this area of finance is very under researched.
9. This paper contributes to the responsible investment literature by theoretically challenging the widely held belief that integrating ESG screens in investment strategies must lead to a diversification penalty compared to otherwise identical conventional investment strategies. Indeed, the authors find many cases in which portfolio diversification can be improved through the use of ESG screens.