In our previous blog, we discussed that in spite of continued asset growth, ESG-tilt exposure may have hit a recent headwind as geopolitical events have rewarded stocks (e.g., the energy sector) not generally loved by portfolios seeking an improved ESG profile. Some may conclude that ESG investing is a liability for investors with exposure, or on a broader scale, does not reliably allocate capital in a way that contributes to the greater good.
These types of arguments against ESG investing fall apart under even mild scrutiny. The recent historical developments actually strengthen the urgent cases for defossilizing the energy sector and for reducing economic dependence on extractive operations through increased adoption of sustainability practices. Further, it’s increasingly clear that, so far, the logistical and technological weaknesses of the Russian effort have been much more decisive than its considerable military assets.
Critical Lesson: Diversification
In terms of potential lessons regarding ESG strategies, especially from the viewpoint of an institutional equity investor, the most crucial consideration is the need to implement ESG approaches through the lens of portfolio diversification. As we’ve seen in recent months, incorporating ESG considerations into a portfolio usually comes with investment trade-offs. However, the types and magnitude of these potential concessions can often depend more on how you integrate ESG considerations into the portfolio-management process, than on the magnitude of the ESG improvement.
As we’ve argued in previous papers, ESG investing is more effective when it uses the benchmark index as a reference point and then exerts pressure in a moderate and positive direction across a broad swathe of stocks, rather than relying on stock-driven approaches, which include exclusion lists or blanket screening, as well as extreme reliance on a handful of stocks to satisfy their ESG goals (see table below). In contrast, the portfolio approach helps protect against implementation issues, of which the persistently low quality of ESG data is the most serious. Also, it maximizes the potential impact of individual investors, as it creates incentives for positive change across many companies, as opposed to a handful of ESG investor favorites.
ESG IMPLEMENTATION MATTERS
|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.|
Managing Complicated Interactions
Portfolio-driven approaches also help manage the nonlinear interaction of many ESG issues, where the resolution of one issue may be effectively suppressed by other interrelated issues. For example, the use of renewable energy sources can be promoted by the large-scale production of batteries, which in turn relies on raw materials that can be challenging to acquire, unless sustainability practices such as effective recycling are more widespread. A diversified, portfolio-driven approach to ESG investing helps advance on a wider front, making progress faster and more consistent.
Renewables rely on batteries to store clean energy for use when the sun doesn’t shine and the wind doesn’t blow. Battery storage is essential, but the technology has drawbacks for both humans and the environment. Battery production involves extracting raw materials, mainly lithium and cobalt, which requires large quantities of energy and water. Furthermore, mining operations, particularly in the Democratic Republic of Congo, involve child labor and unsafe working conditions. Balancing these ESG issues may be more challenging for stock-driven approaches.
Managing for Risk Budgets
Further, portfolio-driven approaches manage the higher active risk inherent in ESG objectives by allowing for much greater control of the active weight per sector, country, or other systematic factors, than is possible by an overly concentrated ESG bet. During a period of geopolitical upheaval such as we are currently experiencing, and especially when the transitional regime has an uncertain future duration, it is important to be able to preserve an ESG tilt without exceeding a prudent risk budget.
Diversification approaches to ESG also help manage active risk by potentially avoiding ESG bubbles that could occur in isolated companies if they draw unsustainable levels of investor attention. For example, investment in multiple car companies that produce electric vehicles presents a smaller risk than overweighting the most well-known electric-car company, without necessarily compromising on ESG impact.
Stock-driven approaches influence portfolio-driven ESG scores only indirectly since they often give little regard to stocks’ absolute level of ESG scores or index weights, and they operate mostly at the initial stage of the investment process. In contrast, a diversified, portfolio-driven approach targets a specific ESG goal and optimizes holdings accordingly, having the full context of each stock’s ESG profile and potential contribution to the portfolio – they have direct influence on a portfolio’s ESG outcome by design.
What Lies Ahead?
We feel strongly that a portfolio-driven approach is best equipped to address both performance and ESG investing objectives, but that doesn’t mean investors shouldn’t be aware of potential future challenges in this space. Download the full paper to find out three significant issues managers must navigate in the years ahead.
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