Systematic ESG risk and hedge fund

Ick Jin; Ick Jin

doi:10.3934/QFE.2024015

Quantitative Finance and Economics

2024, Volume 8, Issue 2: 387-409. doi: 10.3934/QFE.2024015

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Research article

Systematic ESG risk and hedge fund

Ick Jin ^,

Economic Analysis Department of the National Assembly Budget Office, 1 Uisadang-daero Yeongdeungpo-gu, Seoul, 07233 Korea

Received: 30 March 2024 Revised: 03 June 2024 Accepted: 11 June 2024 Published: 17 June 2024
JEL Codes: C15, G11, G12, G13, G22, G33

We present a framework for linking hedge funds to environmental, social, and governance (ESG) investments based on systematic ESG risk. We proposed a double-factor model to explain the co-movement of asset returns due to two systematic risk factors: Adjusted market risk and systematic ESG risk. Complementing prior work that introduces ESG characteristic indicators as determinants of agents' utility functions, this framework leverages modern portfolio theory by establishing a channel through which systematic ESG shocks affect asset risk and, in turn, equilibrium expected returns. This approach enabled us to estimate empirical market prices for systematic ESG risk from real-world observations and derive the relationship between equilibrium expected returns and the loadings on systematic risk factors. Applying this framework to U.S. equity mutual funds, we found that the loadings of systematic ESG risk were significantly correlated with the expected return of the sorted portfolios. These results suggested that it is possible to design hedge fund strategies that capitalize on systematic ESG risk that varies over time.
- ESG investing,
- systematic ESG risk,
- market price,
- index model,
- hedge fund
Citation: Ick Jin. Systematic ESG risk and hedge fund[J]. Quantitative Finance and Economics, 2024, 8(2): 387-409. doi: 10.3934/QFE.2024015

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Abstract

We present a framework for linking hedge funds to environmental, social, and governance (ESG) investments based on systematic ESG risk. We proposed a double-factor model to explain the co-movement of asset returns due to two systematic risk factors: Adjusted market risk and systematic ESG risk. Complementing prior work that introduces ESG characteristic indicators as determinants of agents' utility functions, this framework leverages modern portfolio theory by establishing a channel through which systematic ESG shocks affect asset risk and, in turn, equilibrium expected returns. This approach enabled us to estimate empirical market prices for systematic ESG risk from real-world observations and derive the relationship between equilibrium expected returns and the loadings on systematic risk factors. Applying this framework to U.S. equity mutual funds, we found that the loadings of systematic ESG risk were significantly correlated with the expected return of the sorted portfolios. These results suggested that it is possible to design hedge fund strategies that capitalize on systematic ESG risk that varies over time.

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