How to Boost Your ESG Scores and Preserve Your Risk-Reward Outcomes
As more investors embrace the importance of incorporating environmental, social, and governance (ESG) considerations into their portfolios, there has been growing interest in managing the potential performance trade-offs that can often be associated with capturing enhanced ESG characteristics.
Investors tend to favor one of two typical approaches to implementing ESG investment strategies: stock- driven and portfolio-driven. Many investors continue to rely on stock-driven ESG exposures when integrating ESG considerations into portfolio construction; however, focusing on portfolio-level exposures appears to be a more efficient approach.
Focusing on stock-level ESG exposures may intuitively seem like the most straightforward way to improve a portfolio’s ESG scores. Yet, our research shows that a stock-driven approach alone can come with steep trade- offs that may significantly limit a portfolio in several ways – especially when the approach relies on excluding a material number of low-rated stocks.
“Yet, our research shows that a stock- driven approach alone can come with steep trade-offs that may significantly limit a portfolio in several ways...”
First, excluding stocks reduces the investment universe, which tends to restrict overall return potential. Fewer names to choose from generally translates into fewer ways to add alpha. Similarly, working with fewer names reduces diversification potential, and increases overall risk relative to the portfolio’s benchmark. Third, and perhaps most importantly, stock- exclusion approaches may not consistently maintain a portfolio’s ESG profile. This potentially introduces a level of unintended exposure variability, the degree of which may grow as the number of exclusions increase.
For example, the consistency of an ESG boost resulting only from stock exclusions may be lower and less consistent than expected, as the improvement of the desired ESG metrics relative to the benchmark is unmanaged and can be quite uneven. (Figure 4, presented later in this paper, demonstrates this point.)
Instead, a more practical approach appears to begin by defining the investor’s ESG investment goals and then focusing on how best to integrate the corresponding constraints based on the overall desired portfolio attributes. In other words, begin with the end in mind. We believe this method offers much greater portfolio control and helps better manage the trade-offs between ESG and risk-reward outcomes to pursue stronger outcomes for both.
In our recent research paper, Constructing ESG Portfolios with Non-ESG Data, we highlighted a method to target portfolio-level ESG outcomes with greater efficiency, scale and dependability without directly relying on stock-specific ESG data. We merely adjusted portfolio-level risk exposures, such as sector and country weights. You can see the results for the overall ESG score presented in that research below (Figure 1). We also presented individual environment, social, governance and carbon proxies in the original paper.
Although this was a very simple experiment, it offered an important proof of concept: Investors may achieve meaningful and consistent ESG portfolio tilts over benchmark scores by adjusting portfolio-level exposures that capture dominant and persistent characteristics inherent in traditional ESG evaluations.
“Investors may achieve meaningful and consistent ESG portfolio tilts over benchmark scores by adjusting portfolio- level exposures that capture dominant and persistent characteristics inherent in traditional ESG evaluations.”
In this paper, we expand on our earlier research to explore how a more sophisticated application of portfolio- driven ESG integration might capture ESG outcomes similar to those produced by a stock-driven exposure approach. Our goal is to understand how your ESG implementation choice – portfolio-driven exposures versus stock-driven exposures – could affect an active, non-ESG strategy with a history of generating alpha. We’ll examine the results across just two dimensions: ESG outcomes and risk-return outcomes.
Step 1: Establish a baseline, non-ESG portfolio
We wanted to start with a strategy benchmarked to an index that offers broad diversification across countries, sectors and constituents to help mitigate the potential negative impact of excluding or suppressing stocks based on their ESG characteristics. Yet, the benchmark should include countries with strong ESG disclosure requirements and transparency, which would help increase the overall quality of individual stock ESG ratings. Accordingly, we sought a strategy benchmarked to the MSCI EAFE Index.
We then selected an Intech EAFE-based strategy with the longest performance history using the underlying simulated performance for the investment process. This portfolio is constructed by starting with the entire investment universe and looking for the target weights that will minimize the active risk subject to (a) the long-term excess-return target and (b) a family of risk constraints. These risk constraints do not include a specific ESG focus, which makes the strategy a valuable baseline for comparing different ESG implementation approaches.
Finally, we compiled the average MSCI ESG ratings for each constituent and tracked the performance and ESG characteristics of the simulated portfolio relative to the index. We use MSCI as the source of the ESG ratings because we believe their database is among the most comprehensive and accurate, and many investors are familiar with it; still, there’s evidence that similar results hold for other ESG data providers. The period covered was January 2007 through June 2021 (Figure 2).
Step 2: Applying ESG implementation methods
Next, we simulated four different hypothetical ESG approaches using the Baseline, Non-ESG strategy as a starting point. We created two based on stock-driven exposures and two more focused on portfolio-driven exposures.
Both portfolio-driven simulations integrated two ESG lenses in conjunction with constraints for other types of portfolio risks. The first lens used external ESG attributes as inputs, such as stock-specific ESG scores from third-party rating providers. The second lens applied internally generated ESG attributes based on common, stable ESG characteristics, such as sector, country and/or security size (See Constructing ESG Portfolios with Non-ESG Data).
The portfolio-driven approaches evaluated how changes in ESG and non-ESG exposures helped strengthen overall portfolio-weighted ESG scores relative to the index. They also considered complementary constraint shifts in other areas, in the context of managing the overall potential ESG, risk and reward exposures. A simple example of this process could be a portfolio targeting reduced carbon exposures, which may warrant a larger- than-normal underweight to the utilities sector.
Step 3: Comparing results
All four simulated portfolios delivered higher portfolio-weighted ESG scores versus the index and the simulated Baseline Non-ESG Portfolio; however, other metrics were markedly different (Figure 3).
Both stock-driven ESG portfolios outperformed the index, but their excess returns were notably lower than both the Baseline Non-ESG Portfolio and their portfolio-driven ESG counterparts.
In terms of active risk, Stock Ex 10 and Portfolio Tilt 10 both exhibited comparable tracking error to the Baseline Non-ESG portfolio. In contrast, the Stock Ex 50 and Portfolio Tilt 50 experienced somewhat higher tracking error, the former due primarily to reduced diversification and the latter due to the relaxation in its non-ESG constraints. Overall, however, these modest trade-offs seem acceptable given the meaningful improvement in ESG characteristics.
Both strategies employing the portfolio-driven ESG approach generated information ratios more in line with the Baseline Non-ESG portfolio than the stock-driven ESG portfolios, particularly the Stock Ex 50 portfolio, which exhibited a notable deterioration in performance efficiency.
In addition to calculating each simulation’s portfolio-weighted ESG rating average across the entire period, we also evaluated how these scores changed over time. Both portfolio-driven strategies experienced more stable ESG improvements versus their stock-exclusion counterparts (Figure 4). The Stock Ex 10 portfolio, in particular, generally saw much higher fluctuations in its portfolio-weighted ESG ratings at any given time.
Why is there less consistency with stock-driven approaches? These approaches influence portfolio-level ESG scores only indirectly since their exclusion screens give little regard to stocks’ absolute level of ESG scores or index weights, and they operate only at the initial stage of the investment process: the determination of the investment universe. In contrast, portfolio-driven approaches target a specific ESG goal and optimize 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.
In our view, the key takeaway from these simulations is both clear and compelling. Portfolio-driven ESG implementations delivered notable and more consistent ESG improvements while essentially preserving the level of baseline portfolio’s excess return and tracking error. The stock-driven approaches also offered favorable, if less consistent, ESG improvements, but these came at a cost in the form of reduced returns and performance efficiency.
“Portfolio-driven ESG implementations delivered notable and more consistent ESG improvements while essentially preserving the level of the baseline portfolio’s excess return and tracking error.”
It’s no surprise that incorporating ESG considerations into a portfolio usually comes with investment trade-offs. However, the types and magnitude of these potential concessions can often depend on how you integrate ESG into the portfolio-management process.
A conventional approach that focuses on stock-driven exposures — especially those that simply exclude stocks based on pre-determined ESG ratings—can be ham-fisted and quite disruptive to performance for many investment processes without necessarily guaranteeing a minimum level of ESG improvement. This can risk putting investors in the difficult position of trying to decide how much return they may be comfortable giving up in exchange for an enhanced ESG profile.
The good news: there are more efficient ways to implement ESG considerations. Our research shows that by focusing on managing overall portfolio characteristics and exposures rather than only restricting individual securities, it’s possible for broadly diversified strategies to pursue a desired minimum level of ESG improvement without materially damaging long-term return or tracking error. The result can be a powerful win-win for investors, delivering effective ESG investment strategies without overly restricting outperformance potential.
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