In our previous blog, we examined how low volatility stocks – and the heuristic-based approaches that rely on them – are seemingly in conflict with reduced carbon exposure vs. a cap-weighted index. And for those naïve, low vol stock-based portfolios, that may remain the case.

Fortunately, for those investors attempting to do their part in combatting the potentially catastrophic effects of climate change, there are better alternatives. 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:

1. Build a defensive portfolio using stock-price variances and covariances to target portfolio volatility-reduction while managing other objectives, such as performance relative to a cap-weighted benchmark and carbon intensity.
2. Start with a low-volatility index and actively enhance it by contributing alpha and additional risk controls, such as carbon reduction.

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 in the figure below. The portfolio starts with a baseline carbon intensity that’s 26% 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 11% below index levels – a 37% reduction from the baseline – with just a 70 bps 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 26% 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 chart 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 26.4% 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.

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If you want the full story on why low vol and low carbon are at odds to begin with, you may want to download our latest eBook, “Low Vol Investing on a Low Carb(on) Diet” - we promise, it's a quick read.

1. Intergovernmental Panel on Climate Change (IPCC), 2021: Climate Change 2021: The Physical Science Basis.

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