What’s the Most Effective ESG Investment Approach?

As more investors embrace the importance of incorporating environmental, social, and governance (ESG) considerations into their portfolios, there has been growing interest in managing the potential performance trade-offs that can often be associated with capturing enhanced ESG characteristics.

Investors tend to favor one of two typical approaches to implementing ESG investment strategies: stock-driven and portfolio-driven. Many investors continue to rely on stock-driven ESG exposures when integrating ESG considerations into portfolio construction; however, focusing on portfolio-level exposures appears to be a more efficient approach.

Stock-Driven ESG Approaches Invite Challenges

Focusing on stock-level ESG exposures may intuitively seem like the most straightforward way to improve a portfolio’s ESG scores. Yet, our research shows that a stock-driven approach alone can come with steep trade-offs that may significantly limit a portfolio in several ways – especially when the approach relies on excluding a material number of low-rated stocks.

We find three key challenges with stock-driven ESG implementations:

1. Excluding stocks reduces the investment universe, which tends to restrict overall return potential. Fewer names to choose from generally translates into fewer ways to add alpha.
2. Working with fewer names reduces diversification potential, and increases overall risk relative to the portfolio’s benchmark.
3. Stock-exclusion approaches may not consistently maintain a portfolio’s ESG profile. This potentially introduces a level of unintended exposure variability, the degree of which may grow as the number of exclusions increase. For example, the consistency of an ESG boost resulting only from stock exclusions may be lower and less consistent than expected, as the improvement of the desired ESG metrics relative to the benchmark is unmanaged and can be quite uneven.

Instead, a more practical approach appears to begin by defining the investor’s ESG investment goals and then focusing on how best to integrate the corresponding constraints based on the overall desired portfolio attributes. In other words, begin with the end in mind. We believe this method offers much greater portfolio control and helps better manage the trade-offs between ESG and risk-reward outcomes to pursue stronger outcomes for both.

Targeting ESG Outcomes at the Portfolio-Level

In our recent research paper, Constructing ESG Portfolios with Non-ESG Data, we highlighted a method to target portfolio-level ESG outcomes with greater efficiency, scale and dependability without directly relying on stock-specific ESG data. We merely adjusted portfolio-level risk exposures, such as sector and country weights. You can see the results for the overall ESG score presented in that research below (Figure 1). We also presented individual environment, social, governance and carbon proxies in the original paper.

“...this method offers much greater portfolio control and helps better manage the trade-offs between ESG and risk-reward outcomes to pursue stronger outcomes for both.”

Although this was a very simple experiment, it offered an important proof of concept: Investors may achieve meaningful and consistent ESG portfolio tilts over benchmark scores by adjusting portfolio-level exposures that capture dominant and persistent characteristics inherent in traditional ESG evaluations.

Need the Evidence?

We’ve written a research paper on how a more sophisticated application of a portfolio-driven ESG integration might capture ESG outcomes similar to those produced by a stock-driven exposure approach. Our goal was to understand how your ESG implementation choice – portfolio-driven exposures versus stock-driven exposures – could affect an active, non-ESG strategy with a history of generating alpha. Download it here.

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