Forecasting portfolio volatility by integrating financial risk with ESG risk

The study aims to verify whether the consideration of a risk measure based on environmental, social and governance (ESG) factors can reduce the difference between the ex-ante financial risk and expost volatility of asset portfolios. The statistical models are run on 17,996 firm-year observations (3,332 listed, active firms from 55 countries and 10 industries) in 2007–2015. According to our main results, the forecasting effectiveness of traditional financial risk measures can be improved by integrating financial risk with an ESG risk measure that considers the ESG entropy of the portfolio. Other similar long-run risk measures, such as issuers’ credit ratings, do not reveal the same forecasting power. By reducing unexpected volatility, especially in the medium term, the ESG risk measure provides investors and fund managers with a useful metric for decision making.