Concentration risk in ESG investing

In the past few decades, institutional investors (like pension funds and insurance companies) have predominantly followed investment strategies that closely track broad market indices. The resulting equity portfolios generally contain thousands of individual stocks stemming from many different countries and economic sectors. More recently, a trend has arisen for institutional investors to hold more concentrated portfolios that perhaps contain only a few hundred (or even fewer) stocks (e.g., Schoenmaker and Schramade, 2019). Several developments have contributed to this trend.

First, the increasing focus on ESG and other forms of responsible investments have led investors to pursue exclusion strategies that exclude individual companies, economic sectors or countries. Second, institutional investors concerned about reputational risks increasingly feel compelled to “know what they own” – which is challenging for portfolios with many stocks. Third, ESG risk management is an important motivation for more concentrated portfolios since ESG risks such as climate risks are complex and hard to measure. Further, new regulations like the EU Corporate Sustainability Due Diligence Directive (CSDD) place more emphasis on ESG risks in the entire supply chains of companies, which are already difficult to assess for portfolios with a limited number of stocks.

It is possible that this trend towards more concentrated portfolios involves trade-offs with more traditional, financial objectives of portfolio management. In particular, such strategies could lead to concentration risk in equity portfolios, translating in insufficient diversification, greater downside risk, and/or insufficient exposure to the equity risk premium. We outline research on such trade-offs and on the question to what extent, and under what conditions, these developments in ESG investments could undermine financial performance.

The main research question of this project is: “How is the financial performance of global equity portfolios affected by greater concentration based on ESG and other criteria?” We aim to use historical data for stocks in a large number of countries over the past few decades to address this question.