Not many investment themes have sparked as much controversy and divergence in opinion as sustainable investing. This is not surprising—most investment strategies are constructed with the intention or expectation to achieve certain risk and/or return objectives that are well defined and measurable.
Sustainable investing, on the other hand, tends to be multidimensional, and its impacts on long-term risk and return are not yet fully understood. Additionally, this investment style is characterized by a number of complexities, including multiple objectives (e.g. ethical and long-term investment) and modelling difficulties arising from data coverage, quality and standards. While there is a growing belief that rules-based strategies incorporating sustainable factors may offer investors potential long-term outperformance compared to standard market cap weighted indices, sustainable strategies are not yet directly associated with a particular risk-return profile.
Replicating ESG/SRI indices: portfolio management Aspects
As the ESG/SRI index space has grown and evolved rapidly over the past several years in terms of number of different index series and construction methodologies, so have the portfolio management considerations related to implementing these indices efficiently, including liquidity, turnover, valuation levels, and treatment of corporate actions. These considerations are particularly relevant to non-market cap weighted indices that either weight stocks by sustainability metrics or by a combination of sustainability and risk premia metrics.
The implementation process of index portfolios combining sustainability and risk premia factors involves timely, detailed, precise and pragmatic consideration of liquidity (tends to be lower than market cap), turnover and cost (tends to be higher than market cap), and corporate events (specific rules apply to treatment of corporate actions).
Applying ESG/SRI exclusions to rules-based portfolios
Many institutional clients maintain lists of stocks/sectors they do not want to hold in their portfolios because these stocks/ sectors contravene their ethical policies. There are two potential approaches to implementing exclusion lists in index equity portfolios. In the first approach, stocks/sectors are excluded both from the index and from the portfolio, therefore the portfolio tracks a modified version of the original index, assuming these stocks do not exist. In the second approach, the original index remains unchanged, but stocks are excluded from the portfolio by using stratified sampling or optimization techniques to minimize tracking error. Clients often ask us which approach is better. We implement both approaches successfully and recognize that both have merits and deficiencies.
Constructing custom rules-based portfolios via tilts
A number of sustainable investing themes have emerged recently, including:
- Determining potential sources of material risk and alpha. For example, the opportunities emerging from the transition to the low carbon economy are likely to be a potential source of long-term returns.
- Impact investing, characterized by a move from output-driven ESG integration to measuring and reporting the social and environmental impact of investments in companies, funds, etc.
- Increasing the diversity of approaches to integrate sustainable factors in rules based portfolios, driven by heterogeneity of investors’ time horizons, risk tolerance, beliefs relating to sources of risk premia, etc.
Some of the factors behind this increasing diversity of approaches include:
- Different motivations for ESG integration: ethical and/or value-based considerations (e.g. labor management), or long-term risk-return management (e.g. risk and opportunities arising from the transition to the low carbon economy).
- Different data sources in terms of coverage and quality: e.g. MSCI ESG Metrics, Trucost, Sustainanalytics, South Pole, etc.
- ESG data is increasingly seen as an additional source of information, unrelated to traditional sources of risk premia (e.g. governance-related factors).
- Different levels of investors’ knowledge, awareness and preferences for implementing sustainable factors (e.g. exclusions, tilts, engagement, etc.).
We next review two examples of our work in this area: incorporating climate-related factors in a portfolio, and integrating governance scores in a portfolio.