Creating a sustainable core: Balancing ESG and risk in index portfolios

BlackRock |10-May-2019

Capital at risk. All financial investments involve an element of risk. Therefore, the value of the investment and the income from it will vary and the initial investment amount cannot be guaranteed.

With sustainability increasingly becoming the future of investing, investors are looking to express their environment, social and governance (ESG) views across their portfolios. However, in the equity space, where many core portfolios are index-based, implementing ESG considerations often entails a higher tracking error than investors may be willing or able to accept. We believe a risk-based ESG optimisation approach could offer investors a potentially attractive avenue to explore.

How to balance ESG and risk objectives in equity portfolios

Managing active risk

Our research suggests that by applying a risk-based optimisation process to control a portfolio’s ESG score versus its tracking error, we may improve a portfolio’s ESG score significantly without having to accept large deviations in risk relative to its underlying benchmark. What’s more, the results of our hypothetical simulation suggest that for core equity portfolios much of the ESG improvements could be gained with relatively minimal tracking error. Moreover, as the tracking error is increased, the additional benefit gained becomes increasingly marginal. The below figure illustrates the trade-off between tracking error and ESG rating for the MSCI World Index.

Trade-off between tracking error and ESG rating/ underlying scores

Chart showing trade-off between tracking error and ESG rating/ underlying scores.

Source: Source: MSCI, BlackRock calculations as of 30 November 2017. Notes: The above is based on a simulation that aims to maximise a hypothetical portfolio’s ESG rating. In constructing the hypothetical portfolio, BlackRock takes all companies in the MSCI World Index and using MSCI ESG ratings and underlying scores performs a standard mean variance optimisation for each given tracking error. The forward looking tracking error is an estimation that uses the BlackRock Fundamental Risk for Equity model. This does not represent an actual portfolio, fund managed by BlackRock or investable product, nor is it a recommendation to adopt any particular investment strategy. Indices are unmanaged and used for illustrative purposes only. They are not intended to be indicative of any fund or strategy's performance. It is not possible to invest directly in an index. The analysis is based on a hypothetical simulation and assumes no changes in external factors or transaction costs. It is not indicative of actual or future returns.

Incorporating carbon emissions

In addition to targeting an overall ESG score, investors can also target multiple ESG-related objectives. Most notably this includes a reduction in a portfolio’s carbon footprint. The relationship between carbon emission and ESG scores is not necessarily consistent – companies with low carbon emissions may, for instance, perform poorly in other areas such as governance. Overall, though, we find that in our simulation higher ESG scores generally lead to lower portfolio emissions, with a majority of the carbon reduction occurring at relatively low levels of tracking error.

Not just developed markets

Emerging market companies generally have lower ESG scores compared to their developed market counterparts. This is partly due to differences in the legal and regulatory framework, but also reflects a lack of company reporting. Hence, risk-based optimisation will tend to yield lower levels of improvement in ESG scores relative to developed markets. While it is feasible to target a higher overall ESG score, we find that it will entail a higher tracking error compared to the developed market equivalent.

A long-term improvement

Our hypothetical optimisation suggests that it may be possible to achieve consistent improvements in ESG ratings. The ESG improvement over time can be explained by the steady overall ESG distribution of companies. It is true that an individual company’s ESG rating can and does change, but on a sector-relative basis, the distribution tend to remain consistent. The optimised approach will always result in a higher ESG rated portfolio versus its benchmark, however the magnitude of the improvement might change over time. What is likely to remain stable will be the tracking error, albeit that the results may vary by region.

Jessica Huang
Director, Head of Americas and APAC Platform Strategy and Innovation on the BlackRock Sustainable Investing team
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Katharina Schwaiger
Director, Factor Based Strategies
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