UNDERSTANDING R³: HORAN’S PROPOSAL FOR ESG-ADJUSTED PERFORMANCE MEASUREMENT (CFA INSTITUTE, 2022)

EXTERNAL ARTICLE

Estimated reading time: 3 min.

The integration of ESG (Environmental, Social, and Governance) factors into portfolio evaluation is no longer optional — it’s a necessity. But how can we objectively assess both financial performance and responsible investing practices in a single, meaningful metric?

In 2022, James Horan, from the CFA Institute Research Foundation, proposed a novel framework named R³ — standing for Risk, Return, Responsibility. This framework seeks to capture a more complete picture of portfolio management by combining classic risk-adjusted returns with an ESG performance component.

WHAT IS R³?
 

Horan’s R³ metric combines two key elements:

1. A traditional Sharpe ratio, measuring excess return per unit of total portfolio risk.

2. An ESG quotient, designed to assess how far the portfolio’s ESG score deviates from its benchmark.
    

By normalizing the ESG spread using benchmark dispersion, the quotient becomes dimensionless, comparable across universes, and less sensitive to absolute score levels. In theory, it allows investors and analysts to identify managers who not only deliver performance but do so while meaningfully distancing themselves from the market’s ESG profile.

WHY DOES IT MATTER?
 

This approach has several advantages:

• It offers a combined signal for assessing financial and ESG performance.

• It provides a benchmark-aware view of responsibility.

• It supports multi-dimensional ranking of managers or portfolios.

Yet, it also raises a number of technical and conceptual challenges — especially around:

• the interpretability of combining heterogeneous quantities,

• the sensitivity to benchmark composition, and

• the lack of direct link between ESG spread and manager skill.

Read the source article: Horan, J. S. (2022). Risk, Return, and Responsibility: ESG and Performance Measurement. CFA Institute Research Foundation Briefs