By Kathryn Mohan McDonald
There is a perceived trade-off between ESG goals and investment return. Backward-looking studies attempting to link environmental, social and governance criteria to investment performance are increasingly ubiquitous, but many run into difficulties thanks to a limited data history or failure to control for well-known common factors like beta, value, or size.
If the focus is instead forward-looking we should focus on portfolio fundamentals: if an ESG-integrated portfolio exhibits the same fundamental characteristics as one that does not incorporate sustainability or ethical factors, there is every reason to suppose that its long-run performance will be very similar. Put differently, the inclusion of ESG criteria should not meaningfully change a strategy’s hallmark fundamental characteristics relative to the same strategy without an explicit ESG component.
It is important not to assume that ESG will necessarily be a source of excess return, although this might become true in the future. None of this is meant to imply that a portfolio containing considerations for sustainability and ethical impact will be identical to one without, but in the absence of forward-looking return assumptions for ESG characteristics (net of all other attributes, like industry or country) it is possible to build an ESG-integrated portfolio that will not make sacrifices along traditional risk and return dimensions.
How is this possible? First, a large opportunity set of stocks is key. Breadth is required when it comes to both traditional (fundamental) equity coverage as well as ESG coverage. While every stock is not a candidate for every portfolio, it’s important to not be restricted by a lack of attractive candidates due to coverage limitations during portfolio construction.
Next, it is important to consider how traditional stock fundamentals and ESG criteria interact. Even in the presence of ample coverage, if the characteristics of these criteria were in stark opposition to traditional alpha or smart beta concepts, building a portfolio with a dual emphasis would be difficult. When looking carefully at the data, there are very low cross-sectional correlations between ESG data and traditional fundamental stock data. This orthogonality makes it much easier to achieve the goal of constructing ESG-integrated portfolios that do not sacrifice desired risk and return characteristics.
The following examples compare two sample smart beta equity portfolios – one with explicit ESG integration, the other without. The selection universe for each is the MSCI World Index. The goal of this type of investment, generally, is to produce greater-than-Index returns, at lower-than-Index risk. One way to achieve this is to pick high earnings quality, low volatility names. ESG can be integrated into one sample portfolio by favouring stocks with very strong ESG scores and omitting stocks for which the opposite is true. Additionally, it is also important to ensure there is no exposure to stocks representing strong controversy risk.
Exhibit 1 compares the ESG score distributions for the two smart beta portfolios, as well as for the MSCI Index on 30 June 2016.
Exhibit 1
By design, inclusion of sustainability criteria in the portfolio construction process shifts portfolio exposure towards the more attractive ESG names. The concern on the part of investors worried about a trade-off between ESG and future portfolio return would be that the inclusion of ESG criteria has somehow altered the strategy’s fundamental profile.
In Exhibit 2, each portfolio is shown along the key dimensions of Return on Equity (a component of earnings quality), market Beta, and stock specific risk. In this example, the inclusion of ESG criteria has not significantly compromised the core characteristics of the smart beta approach.
In summary, one need not sacrifice portfolio return for the sake of ESG improvement so long as integration in the portfolio construction process is done in such a way to preserve the fundamental characteristics of the strategy. This is possible with access to an especially broad selection universe and ESG criteria that are minimally correlated with traditional equity fundamental and risk measures.
Kathryn Mohan McDonald is director of investment strategy, Rosenberg Equities
