Governments and companies worldwide are committing to reducing greenhouse gas emissions to avoid catastrophic environmental and economic impacts. To aid this transition, asset owners and asset managers are turning to low carbon investing with the goal of becoming Net Zero.
Unfortunately, climate-minded investors also seeking to de-risk their equity portfolios with defensive, low volatility equity strategies face a challenge. After all, many of the most defensive, least volatile stocks are also the most egregious carbon emitters.
Low volatility investors can embark on two parallel paths for simultaneously targeting carbon and volatility reduction relative to cap-weighted benchmarks. Both require a portfolio-driven approach.
Focusing on the portfolio as a whole opens up investment opportunities unnecessarily excluded by overly restrictive individual-holdings limitations. The key is the covariance matrix. A broader, less restricted opportunity set allows a portfolio optimization process to consider a broader range of correlations and risk management objectives, making it possible to achieve both carbon and volatility reductions.
Unlock the Covariance Matrix
As we’ve seen, companies in the utilities sector exhibit lower volatility, but they are also high carbon emitters, at least collectively. Fortunately, a portfolio-centric approach taps an expanded investment universe, allowing you to avoid the sector’s highest carbon emitters while retaining portfolio-level volatility characteristics.
To demonstrate this concept, we constructed a hypothetical global low volatility strategy and adjusted carbon reduction targets to see the change in the exposure to utilities (see figure below). The portfolio starts with a baseline carbon intensity that’s 25% higher than the MSCI World Index and utilities exposure that’s 7.7% higher than the Index. The first few carbon reduction targets show that a significant drop in carbon intensity requires only a modest change in utilities exposure.
For example, you can reduce carbon intensity to 10% below index levels – a 35% reduction from the baseline – with just a 1% change in utilities exposure. Thus, eliminating a few of the sector’s worst carbon-emitters affects portfolio-level carbon intensity significantly. With higher levels of carbon reduction, the marginal change in utilities exposure does increase. Reducing carbon intensity 70% relative to the benchmark reduces the utilities overweight to 2.8%, or about two-thirds lower than the baseline low volatility portfolio.
Preserving a Low Volatility Profile
A 70% reduction in carbon intensity versus the benchmark seems substantial, but how does such a change affect volatility reduction? What are the trade-offs? We can examine these questions by continuing the analysis of our hypothetical global low volatility portfolio.
Again, we’ll start with a baseline carbon intensity that’s 25% higher than the MSCI World Index, but now we’ll begin with the corresponding baseline volatility reduction, which starts at 31%. Next, we reduce carbon intensity down to 90% below index values to see the effect on volatility reduction (see figure below).
Impressively, volatility reduction remains steady until we reduce relative carbon intensity beyond 70%. Yet, even with carbon intensity 90% lower than cap-weighted index levels, portfolio volatility is still an impressive 26.6% lower than the cap-weighted index. As you can see, very high levels of carbon reduction are possible without materially affecting volatility reduction.
The scientific consensus is that the global economy needs to become less carbon-intensive to avoid calamitous impacts.1 Directing investment capital toward decarbonization efforts is one way our industry can support this sustainability goal; however, low carbon investing appears incompatible with de-risking portfolios using traditional low volatility equity strategies focused on low volatility stocks. But, as we’ve shown, harmonizing low carbon and low volatility investing is indeed possible.
Not only is it possible, but we’ve found you can achieve significant reductions in carbon intensity without materially affecting volatility reduction. By focusing on portfolio-level results, forward-thinking low volatility equity managers are no longer limited to holding low volatility stocks. Instead, managers can use stock-price variances and covariances to target portfolio-level volatility while managing risk exposures – including carbon intensity.
Operating with an expanded opportunity set, low volatility equity managers can make better use of a wider range of stock correlations and risk controls, allowing them to target both carbon and volatility reduction relative to cap-weighted benchmarks – at the same time.
Download the Whole Paper
The insights we’ve shared here on reconciling low volatility and low carbon investing is part of a helpful paper we have on the subject, “Can You Make Low Vol and Low Carbon Investing Compatible?” We invite you to download the whole paper and make it part of your sustainable investing library.
1. Intergovernmental Panel on Climate Change (IPCC), 2021: Climate Change 2021: The Physical Science Basis.
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.
Past performance is no guarantee of future results. Investing involves risk, including possible loss of principal and fluctuation of value. Information that is based on past results or observations is not necessarily a guide to future results, and no representation or warranty, express or implied, is made regarding future results.
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.
Index returns do not reflect transaction costs or the deduction of fees. It is not possible to invest directly in an index.
There is a risk/reward tradeoff that comes with investing in low volatility strategies. These strategies are likely to underperform the index especially in strong up-markets and there is a possibility they will not achieve the desired level of protection in down markets.
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