Creating a sustainable core

By Deborah Winshel, Katharina Schwaiger

Passive investing has long dominated core equity portfolios, with indices available to implement a range of investment strategies. However, the options have been far fewer for investors to express their environment, social and governance (ESG) views. Furthermore, in many instances it involves accepting a higher tracking error than investors are comfortable with.

As ESG investing evolves, so too have the passive choices available to support it. The latest applies a risk-based optimisation process to control a portfolio’s ESG ratings versus its tracking error. This could be a plus for those investors who don’t want to take too much active risk, relative to their investment policy benchmarks. Indeed our research results for core equity portfolios indicate that much of the ESG improvements can be gained with relatively minimal tracking error, with further marginal benefits decreasing as more risk is taken as the below figure illustrates.

Source:MSCI,BlackRock calculations as of December 2016.

Investors can also customise how they apply ESG parameters, including a focus on carbon reduction or a specific region. Of course not all investment indices can be optimised for the same ESG score if targeting a similar tracking error, due to the differences in ESG characteristics of the underlying assets. Nevertheless, we believe these improvements can persist over time, making ESG optimisation a worthwhile consideration for long-term investors.

Global Head of Impact Investing.
Member of the ETF and index investment product innovation group

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