How to Boost Your ESG Scores and Preserve Your Risk-Reward Outcomes – Pensions & Investments

How to Boost Your ESG Scores and Preserve Your Risk-Reward Outcomes Pensions & InvestmentsRead More

Investors are increasingly aware of the importance of incorporating ESG considerations into their portfolios. This has led to a growing interest in managing the performance trade-offs associated with capturing enhanced ESG characteristics. ESG-focused and portfolio-driven approaches are the most popular for investors. While many investors still rely on stock-driven ESG exposures for integrating ESG considerations in portfolio construction, it seems that focusing on portfolio-level exposures is a more efficient approach. Intuitively, focusing on stock-level ESG exposures might seem like the easiest way to improve a portfolio’s ESG scores. Our research shows that a stock-driven approach can lead to steep trade-offs that can significantly limit a portfolio in many ways, especially if it excludes a substantial number of low-rated stocks. Our research shows that a stock-driven approach can lead to steep trade-offs that can significantly limit a portfolio …”. First, excluding stocks reduces investment universe, which tends towards limiting overall return potential. There are fewer options to add alpha, so there are fewer names to choose from. Working with fewer names also reduces diversification potential and increases overall risk relative the portfolio’s benchmark. The third and most important point is that stock-exclusion strategies may not always maintain a portfolio’s ESG profile. This can lead to unintended exposure variability. The degree of this may increase as more exclusions are added. Stock exclusions alone may result in an ESG boost that is less consistent and predictable than expected. This is because the improvement in ESG metrics relative the benchmark is not managed and can be very uneven. This is illustrated in Figure 4, which will be shown later in this paper. Instead, a practical approach is to first define the investor’s ESG investment goals. Then, focus on how to best integrate the constraints based on the overall portfolio attributes. Also, keep the end in sight. This method allows for greater portfolio control and better management of the trade-offs between ESG outcomes and risk-reward outcomes, allowing for stronger outcomes for both. We recently published a paper, Constructing ESG portfolios with Non-ESG data. This paper highlighted a method to target portfolio level ESG outcomes with greater efficiency and scale without relying on stock-specific ESG information. We only adjusted portfolio-level risk exposures such as country and sector weights. Below is a table showing the results for the overall ESG Score. In the original paper, we also included individual environment, carbon, governance, and social proxies. This was a simple experiment that proved a point: Investors can achieve meaningful and consistent ESG portfolio tilts above benchmark scores by adjusting portfolio levels that capture dominant and persistent characteristics in traditional ESG evaluations. Investors can achieve meaningful and consistent ESG portfolio tilts, which are more consistent than benchmark scores, by adjusting portfolio-level exposures that capture dominant or persistent characteristics in traditional ESG evaluations. This paper expands on our previous research and explores how a more sophisticated portfolio-driven ESG integration could capture ESG outcomes similar as those produced by stock-driven exposures. We want to see how your ESG implementation choices – portfolio-driven versus stock-driven – might affect an active, non ESG strategy that has a history of producing alpha. We will examine the results on just two dimensions: ESG outcomes as well as risk-return outcomes. Step 1: Establish a baseline non-ESG portfolio. We wanted to begin with a strategy that is benchmarked to an ESG-compliant index. This will help to mitigate the potential negative effects of excluding or suppressing stocks due to their ESG characteristics. However, the benchmark should include countries that have strong ESG disclosure and transparency requirements. This would increase the overall quality of individual stock ESG scores. We sought a strategy that was comparable to the MSCI EAFE Index. The Intech EAFE-based strategy was chosen because it had the longest performance history and used the underlying simulation performance for the investment process. This portfolio is built by starting with the entire investment universe, and then looking for the target weights that minimize active risk subject to (a), the long-term excess return target and (b), a range of risk constraints. These risk constraints don’t include an ESG focus. This makes the strategy a useful baseline for comparing different ESG implementation strategies. Finally, we calculated the average MSCI ESG ratings of each constituent and tracked the performance relative to the index. We use MSCI for our ESG ratings as they believe it is the most complete and accurate. Many investors are familiar with it. However, there is evidence that similar results can be found for other ESG data sources. Figure 2 shows the period from January 2007 to June 2021. Step 2: Implementing ESG strategies Next, we created four hypothetical ESG strategies using the Baseline, Non ESG strategy as a base point. Two simulations were based on stock-driven exposures, while two others were based on portfolio-driven exposures. Portfolio-driven simulations combined two ESG lenses with constraints for other types portfolio risks. The first lens used stock-specific ESG scores, which are provided by third-party rating agencies, as inputs. The second lens used internally generated ESG attributes that were based on stable, common ESG characteristics such as security size, country, and/or sector. (See Constructing ESG portfolios with Non-ESG data). Portfolio-driven approaches assessed how changes in ESG or non-ESG exposures contributed to higher overall portfolio-weighted ESG scores relative the index. They also considered other areas that could be subject to complementary constraint shifts, as part of managing overall ESG, risk, and reward exposures. One simple example of this could be a portfolio that targets reduced carbon exposures. This may warrant a higher-than-normal underweight to utilities sector. Step 3: Comparing the results All four portfolios produced higher portfolio-weighted ESG scores than the index or the simulated Baseline Non ESG Portfolio. However, other metrics were significantly different (Figure 3). Excess returns Both stock-driven ESG portfolios outperformed indexes, but their excess return was significantly lower than their portfolio-driven ESG counterparts. Tracking Error Stock Ex 10 and Portfolio Tilt 10 had similar tracking errors to the Baseline non-ESG portfolio in terms of active risks. The tracking error for Portfolio Tilt 50 and Stock Ex 50 was slightly higher, with the former due to less diversification, and the latter due the relaxation of its non-ESG restrictions. These minor trade-offs are acceptable considering the significant improvement in ESG characteristics. Information Ratio Both portfolio-driven ESG strategies produced information ratios that were more in line with the Baseline Non ESG portfolio than the stock-driven ESG portfolios. The Stock Ex 50 portfolio showed a significant decline in performance efficiency. ESG Consistency We also calculated each simulation’s portfolio-weighted ESG rating over the entire period. We also evaluated how these scores changed with time. Both portfolio-driven strategies had more stable ESG improvements than their stock-exclusion counterparts (Figure 4) Particularly, the Stock Ex 10 portfolio saw greater fluctuations in its portfolio-weighted portfolio-weighted ESG ratings at all times. Stock-driven approaches have less consistency. These approaches have a limited impact on portfolio-level ESG scores. Their exclusion screens don’t take into account stocks’ absolute ESG scores or index weights. They also operate at the beginning of the investment process, the determination of the investment universe. Portfolio-driven approaches, on the other hand, are focused on a specific ESG goal, optimize holdings accordingly, and have the full context of each stock’s ESG profile, potential contribution to the portfolio. They can directly influence a portfolio’s ESG outcome through design. These simulations are both compelling and clear, in our opinion. Portfolio-driven ESG implementations produced notable and more consistent ESG gains while essentially maintaining the level of excess return and tracking error for the baseline portfolio. Stock-driven ESG implementations also had positive, but less consistent, ESG results, but at a higher cost in terms of performance efficiency and returns. Portfolio-driven ESG implementations provided notable and more consistent ESG improvement while essentially maintaining the portfolio’s excess returns and tracking error. It is not surprising that ESG considerations in a portfolio often require investment trade-offs. The extent and size of these concessions will depend on how ESG is integrated into portfolio management. Traditional approaches that focus on stock-driven exposures, especially those that exclude stocks based upon predetermined ESG ratings, can be slow and disruptive to investment performance. However, they may not guarantee a minimum level ESG improvement. Investors may find themselves in a difficult position where they must decide how much return to sacrifice for a better ESG profile. There are better ways to implement ESG considerations. Our research shows that broad-based strategies can achieve a minimum level of ESG improvement by focusing on managing portfolio characteristics and exposures, rather than restricting individual securities. This is possible without causing materially adverse long-term returns or tracking errors. This can result in a win-win situation for investors. It allows them to implement effective ESG investment strategies while not restricting their outperformance potential. These views are current as of the publication date. These views are intended for information only and should not be construed or used as investment, legal, tax advice, an offer to sell, solicitation of an invitation to buy, or a recommendation or recommendation to buy or sell any security, investment strategy, or market sector. This material is not intended to provide investment management services to clients in any way. Examples and opinions are intended to illustrate broader themes and are not meant to be indicative of trading intent. They are subject change and may not reflect those of others in the organisation. It is not intended that it is implied or indicate that any illustration/example is currently or was ever held within any portfolio. Forecasts cannot be guaranteed, and the information provided is not complete or up-to-date. There are also no warranties regarding the results of its use. Janus Henderson Investors/Intech is the data source, except where indicated. It has reasonable belief that it can rely on data and information sourced from third parties. Past performance is not a guarantee of future results. Investing can be risky, with the potential loss of principal or fluctuation in value. You may lose your original investment, and the value of your investment could fluctuate. Not all products and services are available in every jurisdiction. This material or the information contained within it may be subject to restrictions. It may not be reproduced, referred or referred too without express written permission. It may not be used in any jurisdiction or circumstance that would make it illegal. Janus Henderson is not responsible if this material is distributed to third parties in any way, whole or part. This material has not been approved by or endorsed any regulatory agency. Janus Henderson Investors is a name under which investment products or services are provided by entities identified in these jurisdictions: (a), Europe by Janus Capital International Limited (reg. no. 3594615), Henderson Global Investors Limited (reg. no. 906355), Henderson Investment Funds Limited (reg. no. 2678531) and Henderson Equity Partners Limited (reg. No.2606646), each registered in England and Wales at 201 Bishopsgate London EC2M3AE and regulated under the Financial Conduct Authority and Henderson Management S.A. B22848 at 2 Rue de Bitbourg L-1273, Luxembourg, and regulated by Commission de Surveillance du Secteur Financier; (b) U.S. by SEC registered financial advisers that are subsidiaries Janus Henderson Group plc; Canada through Janus Capital Management LLC to institutional investors in certain jurisdictions; and (d) Singapore By Janus Henderson Investors Limited (Co. registration number. 199700782N This advertisement or publication was not reviewed by the Monetary Authority of Singapore; (e), Hong Kong by Janus Henderson Investors Hong Kong Limited. This material has not been reviewed or approved by the Securities and Futures Commission of Hong Kong; f) Taiwan R.O.C. by Janus Henderson Investors Taiwan Limited (independently managed), Suite 45A-1, Taipei 101 Tower No. 7, Sec. 5, Xin Yi Road, Taipei (110). Tel: (02) 8101-1001. Financial Supervisory Commission approved SICE licence number 023. (g) South Korea, Janus Henderson Investors, Singapore) Limited to Qualified Professional Investors as defined in the Financial Investment Services and Capital Market Act and sub-regulations. (h) Japan, Janus Henderson Investors, Japan) Limited, regulated and registered by Financial Services Agency as a Financial Instruments Firm, Investment Management Business, Investment Advisory and Agency Business and Type 2 Financial Instruments Business. (i) Australia and New Zealand, Janus Henderson Investors Australia) Funds Management Limited (ABN43 164 177 244, AFSL 44268, AFSL 43 165 177 244, AFSL444266, AFSL 44268, AFSL444266). This information is only for wholesale clients as per section 761G (Cth) of the Corporations Act 2001 (Cth). It is not intended for general public distribution. Intech is allowed to provide financial services to wholesale clients under an exemption from the requirement to hold an Australian financial service license under the Corporations Act 2001. The United States Securities & Exchange Commission regulates Intech under U.S. laws that differ from Australian laws. You represent that you are a wholesale customer by submitting this information. (j) The Middle East by Janus Capital International Limited is regulated by Dubai Financial Services Authority as a Representative office. No transactions will take place in the Middle East. Any queries should be directed to Janus Henderson. Telephone calls may be recorded for mutual protection, customer service improvement and regulatory record keeping. Intech has compiled simulations of performance results and they have not been independently verified. Intech’s simulations use historical data to aid in their mathematical optimization process. Simulations are hypothetical and not real. They are presented to investors to help them understand and evaluate Intech’s investment process and show how a portfolio performed over certain periods. Simulations cannot reflect the results or risks associated to actual trading of an account. There is no guarantee that an actual account will achieve similar results. Simulated results should not be considered as a guarantee, assumption, prediction, or prediction of future performance or that investors will be in a position to avoid losses. Simulations don’t reflect all the market, economic, and implementation factors that could have had an impact on Intech’s trading decisions or management of accounts. These factors cannot be fully accounted and can adversely affect actual results. The net results include the reinvestment and capital gains of all dividends, interest and capital gains. They also reflect the deducting of an annual fee of 55bps for model investment advisory fees. Actual fees paid for advisory services may differ from model fees and may be higher, lower or lower than the model fees. The hypothetical ESG approaches used in simulation are only for illustration purposes and do not reflect the actual performance of any investment. MSCI does not make any express or implied warranties or representations regarding the MSCI data contained in this document and will assume no liability whatsoever. The MSCI data cannot be redistributed or used to create indices, securities, or financial products. MSCI has not reviewed or approved this material. Only for institutional, professional, sophisticated, and qualified investors, qualified distributors and wholesale investors. Not for public viewing. Promotional purposes only. Janus Henderson, Janus, Henderson, Intech, Knowledge Shared, Knowledge Labs and Janus Henderson are trademarks owned by Janus Henderson Group plc, or one of its subsidiaries. (C)Janus Henderson Group plc. AUTHORS: Vassilios Papathanakos, PhD
Executive Vice President

David Schofield, Deputy Chief Investment Officer

President, International Richard Yasenchak CFA

Senior Managing Director

Head of Client Portfolio Management. This sponsored content was not written or approved by the editors of Pensions & Investments. It does not reflect the views of Crain Communications, its parent company.