ESG constraints can create unintentional systematic exposures within equity portfolios.
Once identified and measured, these exposures are easily managed.
Over the past decade, many insurers have incorporated Environmental, Social, and Governance (ESG) investment strategies into their portfolios, either by creating separate ESG mandates or by incorporating ESG constraints across the entire portfolio.
These developments raise the vital question of how ESG criteria alter the risk profiles and the factor exposures of portfolios.
To help address this question, we used the Peer Analytics U.S. Equity Statistical Risk Model, which was built for portfolio oversight using only investable factors to distinguish performance due to market exposures from that due to security selection. Using the model, we compared an ESG constrained S&P 500 Index portfolio with its unconstrained counterpart.
Using ESG ratings from FTSE-Russell, we created a sample ESG constrained index fund by excluding companies with ESG ratings below 2.6 from the S&P 500 Index. This constraint excluded 170 companies representing 23% of the market capitalization of the index.
In this example, ESG constraints materially changed the portfolio’s risk profile, adding 2.7% tracking error relative to the unconstrained S&P 500 Index.
Over 80% of the tracking error to the unconstrained benchmark here is due to passive market exposures that are different from those of the benchmark. These exposures, once identified, can easily be offset with ETFs. For example, the ESG constrained fund has a market beta of 0.86 relative to the S&P index’s market beta of 0.97. In this case, ESG constraints reduce risk and expected return by 11%.
Over three-fourths of relative factor risk in our sample portfolio is due to only two factors: short Market beta and short Consumer Discretionary sector beta relative to the unconstrained index. These exposures may be easily offset with inexpensive investment vehicles such as index funds or ETFs.
We’ve seen how ESG constraints can significantly alter the risk profile and market exposures of portfolios. One option is to adjust the benchmark – this leaves the unanswered question of whether performance is sacrificed.
Instead, investors who have adopted, or are considering, ESG guidelines would be well-served by multi-factor risk models built with investable factors. Such models can identify and offset the unintentional market bets introduced by ESG constraints, thus avoiding potential underperformance.
We would be more than happy to provide a complimentary review of how your ESG guidelines change the risk exposures of your portfolio. Please respond below or email email@example.com if interested.