ESG Meets DeFi: Exploring Time-Varying Linkages and Portfolio Implications

This study delves into the connection between Environmental, Social and Governance (ESG) indices and emerging Decentralised Finance (DeFi) assets. Specifically, it explores the ever-changing, frequency-based linkage between these ESG indices and innovative DeFi assets. Employing the wavelet coherence technique, we analyse a broad range of ESG indices, spanning emerging, developed and US indices, alongside various DeFi assets. This examination covers a period encompassing the COVID-19 pandemic and the Russian-Ukrainian conflict to assess market linkages during extreme events. We then calculate optimal weights and hedge ratios for ESG-DeFi asset pairs to evaluate portfolio implications. Wavelet analysis results frequently show no connection between ESG indices and DeFi assets, underscoring the diversification benefits of adding DeFi to an ESG portfolio. However, this relationship notably strengthens at the pandemic crisis's onset, indicating DeFi assets lose diversification potential during turbulent times. Portfolio allocation should mainly favour ESG indices during normal periods, with minimal variations in optimal weights pre- and post-COVID. Meanwhile, hedge ratio analysis suggests DeFi assets make sound investments during crises, although hedging costs increase during turbulent periods. These findings hold relevance for investors, portfolio managers and policymakers.