Overview
Much research has been made in the past few years about how to integrate ESG in various asset classes; however, ESG research on a total portfolio level—or strategic asset allocation (SAA) level—is still very limited. As a 2019 PRI publication put it, the integration of ESG aspects in SAA "is an area that has received relatively little coverage about what it should mean in practice"[1].
This study seeks to address the current blind spot of research to further facilitate ESG integration comprehensively at an overall multi-asset portfolio level. The specific objective is on (i) understanding the potential impact of integrating ESG factors on risk adjusted returns, (ii) what is the best approach to pursue to minimise impact. Our analysis concludes that it is possible to have portfolios that reduce significantly ESG risks without meaningfully different risk-adjusted returns vs traditional index SAAs at relatively low levels of tracking error ("TE"). We estimate that the optimal ESG impact can be achieved for TEs between 75 and 100bps, although an investor’s preference between their risk budget and ESG utility function will determine their appropriate trade-off between these two measures. Other findings:
- ESG integration can be run for either individual asset classes or at a total portfolio level. The combined approach (optimizing the SAA and implementing via ESG indices) is the most efficient approach from the standpoint of total ESG utility versus tracking error.
- Basic integration optimized across regional indices, sector indices and ESG Indexes provides different levels of ESG improvement that depend highly on index/fund selection. The impact can vary from a reduction of 10% to F-rated (highest risks) stocks and carbon intensity to as much as 80% and 50% respectively for the same tracking error of 25bps.
- Changes in regional weights (e.g. having much more Europe vs US than in the standard market cap-weighted portfolio) improves the portfolio ESG characteristics only slightly.
- Better (ESG) results can be achieved constructing the SAA with traditional sector indexes instead of regional ones.
- Much better results can be achieved overall with allocating to ESG indexes. In this latter case, the share of worst ESG-rated securities[2] can be reduced by ca. 80% and the carbon footprint by 50% vs the traditional SAA – for tracking errors as low as 0.25%.
In the spirit of simplicity and wide applicability, our work has been focused primarily on liquid global asset classes for which there exist a replicable set of underlying indices. As such, we established this framework by leveraging readily available passive ESG indices, which we find sufficient in achieving the various parameters such as climate risk alignment. While we recognize that alternative asset classes and instruments can play a significant role in enhancing the ESG characteristics of a strategic portfolio, this framework is focused on presenting an intuitive, implementable solution for liquid asset allocations.
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