💰 quantitative finance

Market-Implied Sustainability: Insights from Funds' Portfolio Holdings

This paper proposes a Market-Implied Sustainability (MIS) framework that derives firm-level sustainability scores from the portfolio holdings of SFDR Article 9 funds, demonstrating that these market-based metrics capture distinct dimensions of sustainability compared to traditional ESG ratings and offer superior risk-adjusted performance in portfolio tilting strategies.

Original authors: Rosella Giacometti, Gabriele Torri, Marco Bonomelli, Davide Lauria

Published 2026-03-17

📖 5 min read🧠 Deep dive

CC BY 4.0

Original authors: Rosella Giacometti, Gabriele Torri, Marco Bonomelli, Davide Lauria

Original paper licensed under CC BY 4.0 (http://creativecommons.org/licenses/by/4.0/). ✨ This is an AI-generated explanation of the paper below. It is not written or endorsed by the authors. For technical accuracy, refer to the original paper. Read full disclaimer

The Big Idea: "What the Crowd Actually Buys" vs. "What the Report Says"

Imagine you are trying to figure out which restaurants in town are truly "healthy" and "sustainable."

Method 1: The Official Health Inspector (Traditional ESG Ratings)
You look at a report card issued by a health inspector (like LSEG). This inspector visits the kitchen, checks the ingredients, and gives the restaurant a score from 0 to 100 based on their policies, their paperwork, and their public promises.

The Catch: A restaurant might have a perfect report card because they write great policies, but they might still be serving junk food. Also, different inspectors use different checklists, so one might give a 90 while another gives a 60 for the same place.

Method 2: The "Secret Menu" of the Crowd (Market-Implied Sustainability - MIS)
Instead of reading the report card, you go to the parking lot of the town's most famous "Health-Conscious Food Club." You count how many members of this club are eating at each restaurant.

If the "Health-Conscious Club" members are overwhelmingly eating at a specific restaurant compared to everyone else, that restaurant must be truly sustainable in the eyes of people who actually spend money.
If a restaurant has a great report card but the Health-Conscious Club avoids it like the plague, something is off.

This paper is all about Method 2. The authors created a new score called MIS (Market-Implied Sustainability). They didn't ask companies what they do; they looked at what "Green Funds" (specifically the strict "Dark Green" funds in Europe) are actually buying.

How They Did It (The Recipe)

The Players: They looked at about 500 European investment funds.
The Groups: They split them into two teams:
- Team "Dark Green" (Article 9): These are the strictest funds. They promise to only invest in things that are truly good for the planet.
- Team "Regular" (Article 6 & 8): These are standard funds that don't have strict green rules.
The Math: For every single company (like Apple, Shell, or a local bank), they asked: "Is this company in the portfolios of Team Dark Green more often than it is in Team Regular?"
- If Yes: The company gets a high MIS score (The crowd loves them for green reasons).
- If No: The company gets a low MIS score (The crowd ignores them, even if they claim to be green).

The Big Surprise: The Two Scores Don't Match!

The authors compared their new MIS Score against the old ESG Report Cards. Here is what they found:

The Report Card (ESG) loves big, famous companies. Big multinational corporations are good at writing reports, filling out forms, and having big sustainability departments. So, they get high scores.
The Crowd (MIS) loves the "Green Transition" heroes. The funds were actually buying more shares of smaller, innovative companies that are doing the green work (like renewable energy tech or electric vehicle parts), even if those companies are smaller and have less paperwork.
The "Sin" Factor: The "Dark Green" funds were very quick to dump companies involved in controversial things (like weapons or fossil fuels), even if those companies had decent ESG scores.

The Analogy:
Think of ESG scores like a Resume. It looks great on paper, lists all the right skills, and is formatted perfectly.
Think of MIS scores like a Job Offer. It's what the hiring manager (the fund manager) actually decided to pay for.

Sometimes the Resume (ESG) is perfect, but the manager doesn't hire them because they don't fit the team's specific needs.
Sometimes the Resume is messy, but the manager hires them because they have a specific, rare skill (like green innovation) that the Resume didn't highlight well.

Does It Make Money? (The "Wallet Test")

The most important question: Does using this new "Crowd Score" help investors make better decisions?

The Experiment:
The authors created two imaginary investment portfolios:

Portfolio A: Bought stocks with the highest traditional ESG scores.
Portfolio B: Bought stocks with the highest MIS scores (the ones the "Dark Green" funds actually favored).

The Result:

Portfolio B (MIS) performed better. It had lower risk and better returns.
Portfolio A (ESG) did not perform as well. In fact, relying only on the report cards didn't give investors an advantage.

Why?
Because the "Dark Green" funds are smart. They aren't just buying companies with pretty reports; they are buying companies that are actually solving problems and avoiding hidden risks (like scandals or lawsuits) that the report cards might miss.

The Takeaway for You

Don't just trust the label. Just because a fund says it's "Green" or a company has a high "ESG Score" doesn't mean it's the best investment.
Watch what the pros buy. The collective actions of professional "Green Funds" reveal a different, often more accurate, picture of who is truly sustainable.
It's about action, not words. The market rewards companies that are doing the green transition (innovation, low controversy) more than companies that are just talking about it (reporting, policies).

In short: This paper suggests that if you want to invest sustainably, don't just read the brochure (ESG scores); look at the shopping cart of the most serious green shoppers (MIS scores). They seem to know something the brochure writers don't.

1. Problem Statement

The paper addresses a fundamental tension in sustainable finance: the divergence between fundamentals-based ESG ratings (provided by data agencies like LSEG/Refinitiv) and market-implied sustainability assessments (revealed through the actual portfolio choices of asset managers).

The Gap: Traditional ESG scores rely on firm-level disclosures, analyst assessments, and third-party data. However, these scores often suffer from methodological heterogeneity, lack of consistency across providers, and a disconnect from actual investment behavior.
The Question: Do funds labeled as "sustainable" (e.g., under the EU's SFDR framework) systematically invest in firms with high ESG ratings, or do they reflect different, perhaps more nuanced, sustainability signals?
The Objective: To construct a Market-Implied Sustainability (MIS) score that captures the "wisdom of fund managers" by analyzing the relative over- or under-representation of stocks in sustainability-oriented funds compared to the broader market.

2. Methodology

A. Data Construction

Sample: Approximately 500 European equity funds (UCITS) over the period 2010–2025.
Classification: Funds are classified based on the Sustainable Finance Disclosure Regulation (SFDR) as of 2023:
- Article 9 ("Dark Green"): Funds with sustainable investment as their objective.
- Article 8 ("Light Green"): Funds promoting environmental/social characteristics.
- Article 6: Funds with no specific sustainability scope.
Holdings: Granular quarterly portfolio holdings data from LSEG/Lipper, covering ~2,400 European stocks at any given time.

B. The MIS Score Calculation

The core metric, $MIS_i$ , is defined as the difference in the prevalence of a specific asset $i$ between sustainable funds and non-sustainable funds.

$MIS_i = p_{S,i} - p_{NS,i}$

Where:

$p_{S,i}$ : Percentage of Sustainable funds (Article 9) holding asset $i$ .
$p_{NS,i}$ : Percentage of Non-Sustainable funds (Article 6 & 8) holding asset $i$ .
Interpretation:
- $MIS > 0$: The asset is over-represented in sustainable funds (market-implied high sustainability).
- $MIS < 0$: The asset is under-represented (market-implied low sustainability).
- $MIS = 0$: The asset's presence is consistent with the market baseline.
Statistical Significance: The authors apply a Z-test for the difference of proportions to ensure scores are statistically distinct from zero.
Alternative Metric ( $MIS_w$ ): An appendix presents a weighted version based on average portfolio weights rather than binary presence, though the primary analysis focuses on the presence-based metric to reduce noise from diversification strategies.

C. Econometric Analysis

To understand the determinants of MIS and its relationship with traditional ESG, the authors employ Panel Quantile Regression (MMQR):

Model 1: $Q(MIS | X) = f(ESG, \text{Sustainability Variables}, \text{Corporate Controls})$
Model 2: $Q(ESG | X) = f(MIS, \text{Sustainability Variables}, \text{Corporate Controls})$
Variables: Includes Green Revenues, GHG Emissions, Controversies, Board Diversity, Firm Size, P/B, P/E, and Dividend Yield.
Why Quantile Regression? To capture non-linear and heterogeneous relationships across the distribution of scores (e.g., factors driving the "best" MIS firms may differ from those driving the "worst").

D. Portfolio Experiments

The authors test the financial relevance of MIS through two strategies:

Rule-Based Tilting: A long-short portfolio overweighting the top $k$ (100) firms by MIS/ESG and underweighting the bottom $k$ .
Optimized Tilting: Constrained optimization (Mean-CVaR, Mean-EVaR, Mean-Variance, Max Sharpe) where weights are bounded to enforce over/under-weighting of specific sustainability groups.

Benchmark: STOXX Europe 600.
Validation: Performance is compared against 200 randomly generated portfolios to establish statistical significance (90% confidence intervals).

3. Key Contributions

Novel Metric (MIS): Introduces a replicable, market-based sustainability score derived from regulated fund labels and ownership data, distinct from fundamental ESG ratings.
Empirical Divergence: Demonstrates that MIS and traditional ESG ratings capture systematically different dimensions of sustainability. They are not highly correlated and often rank firms differently.
Determinants Analysis: Identifies that MIS is driven by Green Revenues and Controversy Avoidance, whereas ESG scores are more strongly driven by Firm Size and Reporting Capacity.
Financial Relevance: Provides evidence that MIS-based strategies outperform ESG-based strategies in risk-adjusted terms, suggesting market-implied signals contain unique alpha.

4. Key Results

A. MIS vs. ESG Relationship

Low Correlation: The correlation between MIS and LSEG ESG scores is close to zero or negative in intermediate years.
Sectoral Divergence:
- Utilities: High alignment (High MIS, High ESG).
- Automobiles/Banks: High ESG but Low MIS (under-represented in Article 9 funds).
- Tech/Software: High MIS but lower ESG (over-represented in Article 9 funds despite lower fundamental ESG scores).
Top Performers:
- MIS Leaders: Companies involved in the green transition (e.g., EDP Renovaveis, Prysmian, Schneider Electric).
- ESG Leaders: Large multinationals with strong reporting (e.g., Roche, AstraZeneca), which often have negative or neutral MIS scores.

B. Econometric Determinants

Drivers of High MIS:
- Green Revenues: Positive and significant across quantiles (Article 9 funds actively seek green exposure).
- Controversies: Strong negative impact; absence of controversies is a key inclusion criterion.
- Growth Tilt: MIS is positively associated with P/B and P/E ratios and negatively with Dividend Yields and Firm Size. Article 9 funds prefer smaller, growth-oriented firms.
Drivers of High ESG:
- Firm Size: Larger firms have higher ESG scores (likely due to better disclosure resources).
- Policy Adoption: Target reduction policies and Human Rights policies correlate with higher ESG scores.
- Weak Link to Growth: ESG scores show little systematic link to valuation multiples or growth characteristics.

C. Portfolio Performance

MIS Strategies Outperform: Portfolios tilted toward high MIS scores ("Top MIS" and "Bottom ESG–Top MIS") consistently deliver:
- Lower risk (VaR, CVaR, Standard Deviation).
- Lower maximum drawdowns.
- Comparable or superior Sharpe ratios compared to the benchmark.
ESG Strategies Underperform: Strategies based solely on high ESG ratings generally underperform in risk-adjusted terms and often fall within the confidence interval of random allocation (i.e., no significant alpha).
Divergence Strategies: The "Bottom ESG – Top MIS" strategy (overweighting firms with high market-implied sustainability but low fundamental ESG) yields some of the best risk-adjusted returns, highlighting the value of the MIS signal.

5. Significance and Implications

For Investors: MIS scores provide complementary information to traditional ESG ratings. Relying solely on vendor ESG scores may miss firms that are effectively screened by institutional capital (the "market consensus" on sustainability). MIS-based tilting can enhance risk-adjusted returns.
For Regulators: The SFDR labels (Article 9) appear to drive real capital allocation toward specific growth and green-transition sectors, validating the regulation's impact. However, the divergence between labels and ESG scores suggests a need for better alignment between regulatory definitions and fundamental metrics.
For Research: The paper challenges the assumption that ESG ratings are the gold standard for sustainability measurement. It suggests that "revealed preference" (portfolio holdings) may be a more robust indicator of market sentiment regarding sustainability risks and opportunities than "stated preference" (ratings).

Conclusion: The paper concludes that Market-Implied Sustainability is a distinct, economically relevant factor. It captures a "growth-oriented, green-transition" signal that traditional ESG ratings, which are often biased toward large, mature, well-reporting firms, fail to capture. Integrating MIS into asset allocation can lead to superior portfolio outcomes.