Do Higher Portfolio ESG Scores Hurt Your Risk-Adjusted Performance?

In this blog post, we’ll share some research to show you why. We take a hypothetical, non-ESG strategy with a history of generating alpha and integrate ESG considerations using two different focuses: stock- vs. portfolio-driven exposures. Then, we’ll compare ESG and risk-return outcomes for all the hypothetical portfolios.

Step 1: Establish a Baseline, Non-ESG Portfolio
We wanted to start with a strategy benchmarked to an index that offers broad diversification across countries, sectors and constituents to help mitigate the potential negative impact of excluding or suppressing stocks based on their ESG characteristics. Yet, the benchmark should include countries with strong ESG disclosure requirements and transparency, which would help increase the overall quality of individual stock ESG ratings. Accordingly, we sought a strategy benchmarked to the MSCI EAFE Index.

We then selected an Intech EAFE-based strategy with the longest performance history using the underlying simulated performance for the investment process. This portfolio is constructed by starting with the entire investment universe and looking for the target weights that will minimize the active risk subject to (a) the long-term excess-return target and (b) a family of risk constraints. These risk constraints do not include a specific ESG focus, which makes the strategy a valuable baseline for comparing different ESG implementation approaches.

Finally, we compiled the average MSCI ESG ratings for each constituent and tracked the performance and ESG characteristics of the simulated portfolio relative to the index. We use MSCI as the source of the ESG ratings because we believe their database is among the most comprehensive and accurate, and many investors are familiar with it; still, there’s evidence that similar results hold for other ESG data providers. The period covered was January 2007 through June 2021 (Figure 1).

Step 2: Applying ESG Implementation Methods
Next, we simulated four different hypothetical ESG approaches using the Baseline, Non-ESG strategy as a starting point. We created two based on stock-driven exposures and two more focused on portfolio-driven exposures.

Both portfolio-driven simulations integrated two ESG lenses in conjunction with constraints for other types of portfolio risks. The first lens used external ESG attributes as inputs, such as stock-specific ESG scores from third-party rating providers. The second lens applied internally generated ESG attributes based on common, stable ESG characteristics, such as sector, country and/or security size.

The portfolio-driven approaches evaluated how changes in ESG and non-ESG exposures helped strengthen overall portfolio-weighted ESG scores relative to the index. They also considered complementary constraint shifts in other areas, in the context of managing the overall potential ESG, risk and reward exposures. A simple example of this process could be a portfolio targeting reduced carbon exposures, which may warrant a larger-than-normal underweight to the utilities sector.

Step 3: Comparing Results
All four simulated portfolios delivered higher portfolio-weighted ESG scores versus the index and the simulated Baseline Non-ESG Portfolio; however, other metrics were markedly different (Figure 2).

Excess Returns
Both stock-driven ESG portfolios outperformed the index, but their excess returns were notably lower than both the Baseline Non-ESG Portfolio and their portfolio-driven ESG counterparts.

Tracking Error
In terms of active risk, Stock Ex 10 and Portfolio Tilt 10 both exhibited comparable tracking error to the Baseline Non-ESG portfolio. In contrast, the Stock Ex 50 and Portfolio Tilt 50 experienced somewhat higher tracking error, the former due primarily to reduced diversification and the latter due to the relaxation in its non-ESG constraints. Overall, however, these modest trade-offs seem acceptable given the meaningful improvement in ESG characteristics.

Information Ratio
Both strategies employing the portfolio-driven ESG approach generated information ratios more in line with the Baseline Non-ESG portfolio than the stock-driven ESG portfolios, particularly the Stock Ex 50 portfolio, which exhibited a notable deterioration in performance efficiency.

ESG Consistency
In addition to calculating each simulation’s portfolio-weighted ESG rating average across the entire period, we also evaluated how these scores changed over time. Both portfolio-driven strategies experienced more stable ESG improvements versus their stock-exclusion counterparts (Figure 3). The Stock Ex 10 portfolio, in particular, generally saw much higher fluctuations in its portfolio-weighted ESG ratings at any given time.

Why is there less consistency with stock-driven approaches? These approaches influence portfolio-level ESG scores only indirectly since their exclusion screens give little regard to stocks’ absolute level of ESG scores or index weights, and they operate only at the initial stage of the investment process: the determination of the investment universe. In contrast, portfolio-driven approaches target a specific ESG goal and optimize holdings accordingly, having the full context of each stock’s ESG profile and potential contribution to the portfolio – they have direct influence on a portfolio’s ESG outcome by design.

What’s the Takeaway?

In our view, the key takeaway from these simulations is both clear and compelling. Portfolio-driven ESG implementations delivered notable and more consistent ESG improvements while essentially preserving the level of baseline portfolio’s excess return and tracking error. The stock-driven approaches also offered favorable, if less consistent, ESG improvements, but these came at a cost in the form of reduced returns and performance efficiency.

Please download the full research paper to share with your colleagues or add to your personal ESG library.

The information expressed herein is subject to change based on market and other conditions. The views presented are for general informational purposes only and do not purport to address the financial objectives or specific investment needs of any individual reader, investor, or organization. This information should not be used as the sole basis for investment decisions. All content is presented by the date(s) published or indicated only, and may be superseded by subsequent market events or other reasons.

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Simulated performance results have been compiled solely by Intech and have not been independently verified. Simulations are produced with the benefit of hindsight by applying its mathematical optimization process to historical data. Simulations are hypothetical, not real, and are presented to potentially allow investors to evaluate how a portfolio may have performed. Simulations do not reflect results or risks associated with actual trading of an account, and there is no guarantee that an actual account would have achieved similar results. In no circumstances should simulated results be regarded as any representation, guarantee, assumption, or prediction of future performance, or that investors will be able to avoid losses. Simulations do not reflect numerous other material economic, market, and implementation factors that may have impacted trading or decision-making in the actual management of an account and cannot be fully accounted for in the preparation of simulations, all of which can adversely affect actual results. The net simulated results include the reinvestment of all dividends, interest, and capital gains as well as estimated transaction costs, and reflect the deduction of a model investment advisory fee based on an annual fee of 55 bps. Actual advisory fees paid may vary and may be higher or lower than model advisory fees.

The simulated hypothetical ESG approaches are for illustrative purposes only and do not represent the performance of any particular investment.