Forming ESG-Oriented Portfolios: A Popularity Approach

Abstract

Key theories of financial economics seem to be at odds with one another and with observed personalized portfolios. The Popularity Asset Pricing Model serves as a unifying theory by allowing for both rational and irrational investors, individual risk and return expectations, a multitude of pecuniary and non-pecuniary characteristics to impact asset prices, and investors to derive utility from non-pecuniary characteristics. The authors develop a benchmark-relative fund-of-funds alpha-tracking error utility function that directly incorporates an investor’s non-pecuniary preferences, including environmental, social, and governance–oriented preferences. Maximizing the utility function leads to a personalized portfolio that tilt toward characteristics that the investor likes and away from characteristics the investor dislikes while maximizing alpha and minimizing tracking error.