The demand for ESG-based investments is surging and many asset managers now offer strategies that take into account a range of environmental, social and governance issues.
But because ESG risks tend to be evaluated and understood at the individual security level, it can be challenging for multi-asset managers to address ESG considerations while still maintaining returns and portfolio diversification. The reality is that each asset class carries very different ESG-related risks and characteristics, complicating the portfolio construction process.
A key question for investors is how much ESG risk reduction can be achieved through asset allocation alone?
To help come up with an answer, we created a model portfolio with volatility (traditional risk) similar to a typical 60/40 balanced portfolio. We focused only on the equity allocation, as this is arguably the key driver of multi-asset portfolio return. The equity universe also has much broader ESG coverage than fixed income, with ratings widely available across capitalisation ranges, styles and geographies.
We then varied the desired ESG risk exposure and evaluated the resulting return penalty to a series of efficient portfolios. Since our goal was to show what asset allocation alone can do to mitigate ESG risk, we didn’t adjust further to account for sector allocation, geography and security selection.
Modest allocation changes helped reduce ESG risk
First, we found it is possible to reduce the portfolio’s ESG risk using asset allocation alone. In other words, without considering the ESG risks or benefits of any individual securities, the model portfolio's ESG risk could be reduced without giving up much return potential. For example, a 10 per cent ESG risk reduction – considered a reasonable portfolio construction goal – is achievable with a modest return give-up.
However, the allocation changes aren’t inconsequential. And more significant ESG risk reduction undoubtedly requires more substantial allocation changes.
For instance, when decreasing the ESG risk, the model portfolio shifted from value equity into core and then into growth, and there was also a preference for real estate investment trusts (REITs) over other equities. This reflects the more attractive ESG risk profiles of REITs and US large-cap growth equities relative to value.
Interestingly, a position in emerging markets equities (EME) is maintained until the ESG risk-reduction goal becomes quite high. So, while EME looks unattractive in ESG terms in isolation, its return profile is compelling relative to its ESG risk. The result is that for all but the most ESG risk-averse portfolios, EME may provide an attractive trade-off for the exposure taken.
The graphic below illustrates the trade-off in return versus ESG risk for a given level of volatility (standard deviation). It shows the extent to which reducing ESG risk using asset allocation strategies alone increasingly penalises portfolio return.
Figure 1: Reducing ESG risk through asset allocation requires a return trade-off
Source – American Century Investments
Hypothetical illustration. Results not intended to represent any actual investment strategy. Past performance is no guarantee of future results. As above, the graphic
depicts a hypothetical equity allocation in an efficient 60/40 stock/bond portfolio created using American Century’s own capital market risk and return assumptions and sustainalytics ESG asset class scores. This graphic illustrates the return trade-off required to achieve a given degree of ESG risk reduction.
Notably, the trade-off is nonlinear. Initially, a modest reduction in ESG risk allows some asset substitutions, such as introducing REITs in place of other equities, which carry little return penalty. Specifically, we see that we can realise a 10 per cent improvement in ESG risk with relatively modest allocation changes while giving up only 11 basis points of return. This is designated Portfolio B.
However, as we seek to lower ESG risk more meaningfully, we must introduce less favourable trade-offs, such as forcing out mid-cap equity and EME. As a result, the efficient frontier in Figure 1 steepens, penalising return at an increasing rate as we lower ESG risk (see points designated Portfolios C and D). The shape of this curve highlights the extent to which naïve attempts to reduce ESG risk through asset allocation alone may be undesirable.
The implication is clear – asset allocation presents opportunities to fine-tune portfolio-level ESG risk, which can be modestly reduced through allocation adjustments with comparatively little return give up.
But more aggressive ESG risk reduction requires increasingly severe asset substitution and return penalties. As a result, an integrated approach that includes individual security and manager selection is the best way to reduce ESG risk.
Rich Weiss, CIO multi-asset strategies at American Century Investments.
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