Factoring in Sustainability: A Worthy Pair

Mar 16, 2022

The capacity of factor strategies appears large 

Batman and Robin, Simon and Garfunkel. Reflecting my academic bent, Kahneman and Tversky. And for my kids, SpongeBob SquarePants and Patrick Star—the two most annoying cartoon characters ever invented. In the world of investing, factors and sustainability, can potentially be paired to build portfolios that target well known sources of returns with relatively lower carbon exposure, and improved Environmental, Social, and Governance (ESG) characteristics.

Many investors have been evaluating their portfolios with a factor lens during their portfolio construction process. Factor investing’s popularity has led to exponential growth over the past decade. From 2010 through 2021, Factor ETF assets have increased by more than 10x from $51B to $649B.1

Minimum volatility strategies are intended for investors looking for market-like exposures over a full cycle but with lower equity volatility. In fact, USMV is our largest factor ETF at BlackRock, with more than $29B in AUM.2 As a professor of finance at Columbia Business School back in the mid-2000s, I did research that found that stocks with lower volatilities delivered similar returns as the market, while stocks with high volatilities have historically exhibited “abysmally low” returns.3 Since that initial research, a suite of minimum volatility funds have been launched, all aimed at achieving market-like exposures with less overall risk.

More recently, we’ve witnessed a monumental shift toward more sustainable investing. Over the past five years, we have seen AUM in sustainable assets globally more than double from $1.2T in 2016 to $2.55T in 2020.4 In addition to growing client demand, minimum volatility and sustainable investing both share another commonality – namely, less volatile companies have also tended to have better Environmental, Social and Governance (ESG) characteristics.5 So, minimum volatility investors may also be expressing a sustainable view.

The relationship between Volatility, ESG, and Carbon Emissions

Different sectors have different levels of volatility that reflect a variety of underlying risks including regulatory risk, market beta, and technological disruption. The biggest spread in volatilities has been between the energy and consumer staples sectors, where energy has been over two times more volatile than the consumer staples sector.

10-year volatility

Source: MSCI as of 12/31/21. Shows annualized standard deviation based on monthly gross returns data. Sector volatility is calculated based on MSCI USA IMI Sector Indexes.

Intuitively, it would make sense for a minimum volatility strategy to be underweight energy given its relatively higher levels of volatility. Concurrently, some of the worst scoring environmental companies based on MSCI's environmental pillar score are energy companies.6 An underweight to the energy sector can then lead to the dual task of lowering volatility in a portfolio and simultaneously raising its environmental score.

In the data, we also see different sectors also have different levels of carbon emissions.

Average carbon risk by GICS sector

Source: MSCI ESG Research, as of 6/30/2021, based on holdings as of 6/30/2021. Data compares the MSCI USA Index (99.80% carbon intensity coverage by MSCI ESG Research), MSCI USA Minimum Volatility Extended ESG Reduced Carbon Target Index (99.99% carbon intensity coverage by MSCI ESG Research), and MSCI USA Minimum Volatility Index (100.00% carbon intensity coverage by MSCI ESG Research). The MSCI USA Index is the parent index of both the MSCI USA Minimum Volatility Extended ESG Reduced Carbon Target Index and MSCI USA Minimum Volatility Index. For individual securities, carbon risk is measured by tons of carbon dioxide emissions emitted per $1 million of sales revenues. MSCI ESG Carbon Risk is calculated using the portfolio’s weighted average carbon intensity, measured as the portfolio’s overall exposure to carbon intensive companies. It is calculated as the sum of security weight (normalized for corporate positions only) multiplied by the security Carbon Intensity.

An ESG minimum volatility strategy aims to take advantage of the relationships between volatility, ESG characteristics, and carbon emissions in its optimization. The MSCI USA Minimum Volatility Extended ESG Reduced Carbon Target Index, which our newly launched iShares ESG MSCI USA Min Vol Factor ETF, ESMV, seeks to track, aims to create a low-risk portfolio that improves its ESG score and reduces its carbon footprint, relative to the broad market.7

ESG Constraints and Risk Characteristics

ESMV’s index has a dual objective of reducing volatility while also considering ESG characteristics. The fund’s index methodology aims to reduce carbon exposure by 30%and improve its MSCI ESG Score by 20% relative to the parent index (MSCI USA Index).8

Many investors in minimum volatility strategies are keenly focused on risk reduction. As a risk reduction tool, USMV has had a standard deviation that is 18.5% lower than the S&P 500 Index since the fund’s inception.9 How does ESMV look from a risk standpoint compared to our original min vol fund?

Standard Deviation

Source: Morningstar as of 1/11/22. Uses index data for the period 6/3/21 - 1/11/22. ESMV's index, the MSCI USA Min Vol Extended ESG Reduced Carbon Target Index. incepted 6/3/21. Risk (volatility) represented by standard deviation.

We have found in our internal research that ESMV’s index has comparable levels of volatility to USMV’s index. In its short live history, we’ve seen ESMV’s index has had approximately 16.3% less risk than the broad market10 and only slightly higher levels of volatility than USMV’s Index.

While ESMV’s index is designed to incorporate better ESG scores and lower carbon emissions in its construction process, incorporating ESG and carbon emissions has not inhibited the index’s ability to reduce risk relative to the market.

A worthy pair

At BlackRock, we believe climate risk is investment risk. We also believe factors can offer broad, diversified sources of returns. With increased demand from clients for innovative solutions, we believe a dedicated ESG minimum volatility strategy can allow investors to efficiently access equities with potentially lower risk, better ESG scores, and relatively lower carbon intensities – a worthy endeavor!

Our flagship minimum volatility suite (which includes USMV, EFAV, and EEMV) recently celebrated its 10-year anniversary. Now, the next development is to combine an ESG and lower carbon focus alongside factors—not only to pursue the potential change in market preferences over the next decade—but also to offer investors a sustainable approach to seek market-like returns with less risk.

Andrew Ang, PhD
Andrew Ang, PhD
Head of Factors, Sustainable and Solutions for BlackRock Systematic
Andrew Ang, PhD, Managing Director, is Head of Factors, Sustainable and Solutions for BlackRock Systematic. He also serves as Senior Advisor to BlackRock Retirement ...
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