Tri-Criterion Modeling for Constructing More-Sustainable Mutual Funds

One of the most important factors shaping world outcomes is where investment dollars are placed. In this regard, there is the rapidly growing area called sustainable investing where environmental, social, and corporate governance (ESG) measures are taken into account. With people interested in this type of investing rarely able to gain exposure to the area other than through a mutual fund, we study a cross section of U.S. mutual funds to assess the extent to which ESG measures are embedded in their portfolios. Our methodology makes heavy use of points on the nondominated surfaces of many tri-criterion portfolio selection problems in which sustainability is modeled, after risk and return, as a third criterion. With the mutual funds acting as a filter, the question is: How effective is the sustainable mutual fund industry in carrying out its charge? Our findings are that the industry has substantial leeway to increase the sustainability quotients of its portfolios at even no cost to risk and return, thus implying that the funds are unnecessarily falling short on the reasons why investors are investing in these funds in the first place.