The Effect of ESG Screening on Investment Return, Risk and Diversification

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In the past decades, the interest in environmental, social, and corporate governance has grown immensely. An increasing part of investors is interested in the ESG performance of a company before investing in it through financial markets. Also, a great body of research has focused on the effects of ESG performance on financial performance of the firm, and on the financial performance of investing in those highly rated ESG companies. However, there still is a lack of consensus regarding the effects of investing in ESG companies on the return of investment. This thesis forms portfolios based on positive- and negative ESG screening and tries to capture the effects of those screening methods on risk, return and diversification. The findings indicate that both screening methods have no effect on the risk-adjusted return of a European portfolio for a retail investor. In line with prior research this thesis finds lower volatility of ESG screened portfolios, compared to the market portfolio. However, the idiosyncratic risk of the individual stocks in the portfolio is higher for the ESG screened portfolios, which is not as expected. Finally, ESG screening has a significant, but small, effect on the diversification of the portfolio. Overall, portfolios of retail investors in Europe, when well diversified, do not suffer from ESG screening.
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