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