Our research has shown that there is an efficient way to implement ESG objectives into portfolio management without extensive—and usually time- and resource-intensive—individual-security research. The following simplified proof of concept illustrates how ESG characteristics may be effectively captured at the portfolio level using non-ESG data, such as sector and country weights. Focusing on the portfolio level, rather than individual-stock level, can offer a far more streamlined ESG implementation approach. The proxy examples below help demonstrate this point.
Step 1: Assemble the Data
The first step in creating ESG-proxy portfolios is to select a benchmark, in this case the MSCI All Country World Index. We then compile each constituent’s MSCI ratings for environmental, social, governance, and overall ESG and Carbon Emissions Intensity across multiple years.
The historical median scores of these five characteristics for all of the stocks in the index are shown in Figure 1.
Step 2: Calibrate the Weights
Next, we construct five hypothetical cap-weighted portfolios using only the stocks that are in the best 50% for each of the ratings. We’ll call them ESG-restricted portfolios. We then calculate the average sector and country weights for each portfolio. Figure 2 presents the country and sector over-and-under weights for these ESG-restricted portfolios compared to the broader benchmark.
Step 3: Generate the ESG-Proxy Portfolios
The final step in constructing our ESG-proxy portfolios consists of starting with all of the stocks in the original index and uniformly boosting the weights of stocks from sectors and countries that were overweighted in the ESG-restricted portfolios. We applied the following formula to maintain consistency in how we boosted weights of stocks from overweighted sectors or countries in the ESG-restricted portfolios:
A and B are constants based on the relative size of the increase to be reflected, mi, si and ci are the benchmark weight, sector and country of stock i, respectively, and msi and rsi are the benchmark and ESG-restricted portfolio weights for the stock’s sector. Similarly, mci and rci reflect the benchmark and ESG-restricted portfolio weights for the stock’s country. In this analysis, we set A = B = ½.
Evaluating Proxy Effectiveness
Figure 3 shows the resulting ESG ratings of these proxies compared to the ESG-restricted portfolios and the original benchmark. All five ESG-proxy portfolios exhibited meaningful and consistent ESG-tilts over benchmark scores simply by adjusting portfolio-level exposures rather than relying on individual stock considerations. Put another way, we’re able to construct portfolios with favorable ESG characteristics without a direct reliance on stock-level ESG scores.
Find Out More
Our latest research paper expands on how constructing ESG portfolios with non-ESG data can help implement a more efficient and consistent integration of socially responsible factors into portfolio design. Download it here.
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The hypothetical portfolios shown are for illustrative purposes and do not represent any particular investment. Hypothetical portfolios are not real and have many inherent limitations. They do not reflect the results or risks associated with actual trading or the actual results of any portfolio, and have been prepared with the benefit of hindsight. Therefore, there is no guarantee that an actual portfolio would have achieved the results shown. In fact, there will be differences between hypothetical and actual results. No investor should assume that future performance will be profitable, or equal to the results shown.
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