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Exploring the relationship between modern portfolio theory and SDG investing

At first glance, investing to achieve outcomes aligned with the Sustainable Development Goals may appear inconsistent with an optimised portfolio outcome under the modern portfolio theory. However, tailwinds or risks associated with SDG-oriented investments may not be appropriately priced in traditional risk-return assessments. This suggests that assessing the SDG profile of investees – which can serve as a proxy for their externalities –is an important supplement to modern portfolio theory-driven analytical approaches and could contribute to portfolio resilience or improved risk-adjusted returns.

Recently, an increasing number of corporations have announced how they plan to integrate the UN SDGs into their business and operations. The 17 SDGs[1], further delineated in 169 targets and 232 indicators, outline a universal roadmap to a sustainable world “free of poverty, hunger, disease and want, where all life can thrive” by 2030. Some have dubbed this as “the closest thing the Earth has to a strategy.”[2]  

At the same time, investor demand has been growing for ESG[3]-integrated funds and impact funds designed to achieve measurable positive environmental and social outcomes in the real economy. According to the Global Impact Investing Network, the market for such products grew by more than 40% between 2019 and 2020.[4]   

A growing interest in this form of investing has resulted in a desire to deploy capital according to the SDGs, given their status as a globally recognised sustainability framework. To help facilitate SDG-aligned products, service providers have created tools to help evaluate companies’ alignment and/or contribution to the SDGs.

These often present methodological challenges, further compounded by a lack of data availability and common frameworks on SDG performance. Nonetheless, investors have embraced these tools and marketing materials now abound with colourful pictograms of the SDGs purporting to map funds with the goals. According to one 2020 survey of the financial services industry, 50% of asset managers plan to start measuring investments against the SDGs.[5]

Against the backdrop of rising interest in impact investment and SDG products, it seems natural to want to analyse the relationship between the SDGs, investment returns and the modern portfolio theory more broadly, given the ubiquity of the latter in portfolio management.   

Theorising the theory

The modern portfolio theory (MPT) – most often used in the context of Mean Variance Optimisation (MVO) – sets out a framework for creating a portfolio of assets from which the expected return is maximised for a given level of risk borne by the investor.

Certain premises are central to this theory:

  • Investors need to be compensated for holding more risky assets
  • A portfolio’s risk can be reduced through uncorrelated asset diversification
  • Markets are efficient.

In more practical terms, MVO models grounded in MPT rely on historical risk and return data as a primary input to identify ‘optimal’[6] portfolios along an efficient frontier.

Traditional analytical interpretations of MPT do not account for the SDGs (or ESG for that matter). Typically, efforts to shoehorn sustainability considerations into MPT frameworks take the form of an exogenous constraint to the risk-return portfolio optimisation equation, e.g., minimum or maximum exposure to SDG X or Y. By virtue of MPT’s assumptions, adding such a constraint moves investments away from the efficient frontier, making them appear less ‘optimal’. 

SDGs, risk mitigation and portfolio resilience

Interestingly, a survey by the Global Impact Investor Network highlights that two-thirds of impact investors target a market-rate return, with the remaining one-third willing to target a lower return to maximise impact.

Exhibit 1: While most surveyed impact investors target market-rate returns, others are willing to accept less

Source: Global Impact Investor Network, 2020 Annual Impact Investor Survey

As highlighted by exhibit 1, there can be a trade-off between maximising SDG alignment/impact and returns. However, we believe there are also scenarios whereby considering the impact of investments on the SDGs could actually contribute to either risk mitigation or return enhancement that may not be reflected in current market valuations.

This mispricing stems from the fact that investors typically do not pay appropriate attention to systemic risks and market ecosystem considerations in their asset allocation and valuation decisions. This is compounded by the fact that, contrary to one of the underlying assumptions of MPT, investors do not always access the same information.

As a result, risks and opportunities from negative or positive externalities that could be lowered within a portfolio due to close alignment to the SDGs may not be reflected in current valuations (e.g., exposure to green assets with a regulatory tailwind (pos), exposure to future fines from environmental damage (neg)).

In our view, this information gap and potential opportunity from mispricing is due to the complexity of analysis and the fact that these issues are not yet fully mainstream or remain niche. As a result, addressing an SDG may help mitigate portfolio risk or contribute to resilience or a competitive advantage in a way that traditional MPT-based analysis does not capture.

Voices in the financial industry have started to call for a fundamental rethink of MPT to reflect the inclusion of ESG and/or SDG factors. The idea would be that investors would assess the maximum return possible not only for the level of risk taken, but also for the ESG or SDG score of a portfolio,[7] thereby introducing a third, equally weighted, endogenous factor into portfolio construction.[8]   

Identifying the tailwinds

In addition to mispriced risks associated with investments aligned with the SDGs, we believe there is the potential for opportunities aligned with access to fast-growing profit pools associated with achieving the SDGs. These may not yet be appropriately reflected in current valuations. The annual financing gap to achieve the SDGs by 2030 is currently estimated at USD 2.5 trillion.[9]

For example, companies will be able to adjust to climate regulations with much greater ease if they have already incorporated in their business and operating models how they can contribute to SDG 7 (Affordable & Clean Energy) and SDG 13 (Climate Action). And this adjustment will likely be necessary.

Global regulators such as the Securities and Exchange Commission in the US and the UK’s Prudential Regulation Authority are already encouraging increased corporate climate-related disclosures. However, there are other incoming measures that will doubtless catch companies off guard if they are unprepared.

For example, border taxes on carbon and further regulations addressing deforestation and sector-specific measures – such as those focusing on fuels and emissions in commercial shipping and aviation – are all likely to increase in prominence.

The PRI’s Inevitable Policy Response Project attempts to quantify the impact of a potentially disorderly increase in regulation on the real economy and financial markets. As a result, firms already using the aforementioned SDGs as a guide will be better positioned and feasibly have a competitive edge in the face of these stricter regulations.

Climate-related regulation is not the only area where companies that have integrated the SDGs may have the upper hand. Companies that work towards SDG 8 (Decent Work & Economic Growth) may be better placed to respond to increasing calls for organisations to pay employees a living wage.

All in all, investing in consideration of the SDGs could allow a portfolio manager to identify mispriced risk or undervalued opportunities and potentially achieve better-than-‘optimal’ outcomes.

Also read

More articles on sustainable investing


Any views expressed here are those of the author as of the date of publication, are based on available information, and are subject to change without notice. Individual portfolio management teams may hold different views and may take different investment decisions for different clients. This document does not constitute investment advice.

The value of investments and the income they generate may go down as well as up and it is possible that investors will not recover their initial outlay. Past performance is no guarantee for future returns.

Investing in emerging markets, or specialised or restricted sectors is likely to be subject to a higher-than-average volatility due to a high degree of concentration, greater uncertainty because less information is available, there is less liquidity or due to greater sensitivity to changes in market conditions (social, political and economic conditions).

Some emerging markets offer less security than the majority of international developed markets. For this reason, services for portfolio transactions, liquidation and conservation on behalf of funds invested in emerging markets may carry greater risk.


[1] See https://sdgs.un.org/goals

[2] See for instance https://sloanreview.mit.edu/article/supporting-sustainable-development-goals-is-easier-than-you-might-think/

[3] Using environmental, social and governance criteria

[4] See https://thegiin.org/assets/GIIN%20Annual%20Impact%20Investor%20Survey%202020.pdf

[5] See https://www.sc.com/us/2020/11/10/the-50-trillion-question-un-sustainable-development-goals-face-critical-investment-shortfall-standard-chartered-research-finds/

[6] ‘Optimal’ as a concept is intrinsically linked to MPT and MVO, which themselves suffer weaknesses as constructs such as: i) the use of volatility as the only measure of risk; ii) an overreliance on backward-looking data for analysis and iii) insufficient acknowledgement of the uncertainty and assumptions surrounding the inputs of the optimisation. For more on this, see https://www.top1000funds.com/2017/02/we-need-to-be-better-than-optimal/ 

[7]See for example  https://www.unpri.org/academic-research/beyond-modern-portfolio-theory-how-investors-can-mitigate-systemic-risk-through-the-portfolio/538.article  

[8] See for instance https://core.ac.uk/download/pdf/189318713.pdf

[9] UNCTAD World Investment Report, 2014

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