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As more investors embrace the importance of incorporating environmental, social, and governance (ESG) considerations into their portfolios, there has been growing interest in managing the potential performance trade-offs that can often be associated with capturing enhanced ESG characteristics.

Investors tend to favor one of two typical approaches to implementing ESG investment strategies: stock-driven and portfolio-driven. Many investors continue to rely on stock-driven ESG exposures when integrating ESG considerations into portfolio construction; however, focusing on portfolio-level exposures appears to be a more efficient approach.

 

Stock-driven exposures

Portfolio-driven exposures

This approach limits the investment universe relative to a benchmark based on specific stock-level ESG ratings. It may not use overall portfolio-level ESG constraints or exposures in the process; instead, it relies on excluding companies with the least favorable ESG ratings or overweighting those with the most favorable ratings as a way to meet an investor’s sustainability objectives.

This approach may also incorporate stock-level ESG ratings, but it places emphasis on targeting ESG outcomes at the portfolio level, allowing for a larger initial investment universe. The portfolio-driven approach boosts portfolio-level ESG characteristics above the benchmark, commensurate with investor objectives, while adapting the portfolio to manage the resulting impact to performance and risk.

 

Stock-Driven ESG Approaches Invite Challenges

Focusing on stock-level ESG exposures may intuitively seem like the most straightforward way to improve a portfolio’s ESG scores. Yet, our research shows that a stock-driven approach alone can come with steep trade-offs that may significantly limit a portfolio in several ways – especially when the approach relies on excluding a material number of low-rated stocks.

We find three key challenges with stock-driven ESG implementations:

  1. Excluding stocks reduces the investment universe, which tends to restrict overall return potential. Fewer names to choose from generally translates into fewer ways to add alpha.
  2. Working with fewer names reduces diversification potential, and increases overall risk relative to the portfolio’s benchmark.
  3. Stock-exclusion approaches may not consistently maintain a portfolio’s ESG profile. This potentially introduces a level of unintended exposure variability, the degree of which may grow as the number of exclusions increase. For example, the consistency of an ESG boost resulting only from stock exclusions may be lower and less consistent than expected, as the improvement of the desired ESG metrics relative to the benchmark is unmanaged and can be quite uneven.

Instead, a more practical approach appears to begin by defining the investor’s ESG investment goals and then focusing on how best to integrate the corresponding constraints based on the overall desired portfolio attributes. In other words, begin with the end in mind. We believe this method offers much greater portfolio control and helps better manage the trade-offs between ESG and risk-reward outcomes to pursue stronger outcomes for both.

Targeting ESG Outcomes at the Portfolio-Level

In our recent research paper, Constructing ESG Portfolios with Non-ESG Data, we highlighted a method to target portfolio-level ESG outcomes with greater efficiency, scale and dependability without directly relying on stock-specific ESG data. We merely adjusted portfolio-level risk exposures, such as sector and country weights. You can see the results for the overall ESG score presented in that research below (Figure 1). We also presented individual environment, social, governance and carbon proxies in the original paper.

“...this method offers much greater portfolio control and helps better manage the trade-offs between ESG and risk-reward outcomes to pursue stronger outcomes for both.”

Although this was a very simple experiment, it offered an important proof of concept: Investors may achieve meaningful and consistent ESG portfolio tilts over benchmark scores by adjusting portfolio-level exposures that capture dominant and persistent characteristics inherent in traditional ESG evaluations.

Fig 1 Boosting ESG Scores by Adjusting Only Portfolio-Level Exposures-1

Need the Evidence?

We’ve written a research paper on how a more sophisticated application of a portfolio-driven ESG integration might capture ESG outcomes similar to those produced by a stock-driven exposure approach. Our goal was to understand how your ESG implementation choice – portfolio-driven exposures versus stock-driven exposures – could affect an active, non-ESG strategy with a history of generating alpha. Download it here.

Boost ESG Scores and Preserve Risk-Reward Results?  Find Your Win-Win ESG Investing Proposition Learn More

 

 

The views presented are for information purposes only and should not be used or construed as investment, legal or tax advice or as an offer to sell, a solicitation of an offer to buy, or a recommendation to buy, sell or hold any security, investment strategy or market sector. Nor do they purport to address the financial objectives or specific investment needs of any individual reader, investor, or organization. The views are subject to change at any time based upon market or other conditions, are current as of the date indicated, and may be superseded by subsequent market events or other conditions.

Past performance is no guarantee of future results. Investing involves risk, including the possible loss of principal and fluctuation of value. As with all investments, there are inherent risks that need to be considered. The hypothetical portfolios shown are for illustrative purposes and do not represent any particular investment. Hypothetical portfolios are not real and have many inherent limitations. They do not reflect the results or risks associated with actual trading or the actual results of any portfolio, and have been prepared with the benefit of hindsight. Therefore, there is no guarantee that an actual portfolio would have achieved the results shown. In fact, there will be differences between hypothetical and actual results. No investor should assume that future performance will be profitable, or equal to the results shown.

References to third party names such as MSCI ESG ratings do not constitute a sponsorship or endorsement by such company nor does it accept any liability for damage arising from the use of the information, data, or opinions contained herein. MSCI makes no express or implied warranties or representations and shall have no liability whatsoever with respect to any MSCI data contained herein. The MSCI data may not be further redistributed or used as a basis for other indices or any securities or financial products. This report has not been approved, reviewed, or produced by MSCI.

Intech is the source of data unless otherwise indicated, and has reasonable belief to rely on information and data sourced from third parties.