Opportunities of Portfolio Construction Including ESG And Conventional Investments Based on Dynamic Conditional Correlation

The pandemic highlighted social and global inequality and spiked interests in Environmental, Social, and Governance (ESG) investing. ESG assets amounted to $35.3 trillion in 2020 from around $30.7 trillion in 2018 and $22.8 trillion in 2016, reaching a third of current total global assets under management, according to the Global Sustainable Investment Association (http://www.gsi-alliance.org/). This paper investigates the possibilities of portfolio construction that includes the companies with high ESG scores. We consider two groups of financial investments – approximated by the ESG-based and the conventional stock indices. As the correlation between ESG and conventional stock indices is high, the benefits from diversification in the case of a portfolio containing these two assets should disappear. We apply the GARCH models and the Dynamic Conditional Correlation approach to investigate the changing volatility and dynamic dependence. Our results show periods with low conditional correlation. Therefore, the ESG-based investment could be considered a good diversifier in a declining market, while it should not influence the portfolio in the growing market negatively.