Downside Risk Measures and ESG Factors in Optimal Portfolio Construction: Evidence from European Equity Markets

Abstract In this paper, we implement an integrated framework for constructing ESG-constrained, downside-risk-optimized equity portfolios in the European stock market. Extending traditional mean-variance approaches, we employ downside-oriented risk measures-conditional value at risk (CVaR) and semi-variance-to better capture investors’ asymmetric aversion to losses. ESG scores are introduced as binding constraints based on percentile thresholds, ensuring that portfolios comply with predefined sustainability standards. Semi-variance and CVaR objectives are formulated as convex programs to enable tractable optimization. Using data from Euro Stoxx 50 and Euronext 100 constituents, our empirical analysis reveals that: (i) integrating downside risk measures enhances tail-risk protection and may improve performance for loss-averse investors; but (ii) enforcing ESG constraints, particularly at stricter thresholds, leads to reduced diversification and a decline in risk-adjusted returns (e.g., Sharpe and Sortino ratios). These findings highlight the inherent trade-off between sustainability and financial efficiency, underscoring the importance of moderate ESG integration when balancing performance and ethical objectives.