The study by
risklab, a company of Allianz Global Investors that specializes in investment and risk analysis, is one of the first systematic quantitative analysis explicitly examining ESG risk in a portfolio context. It concludes that investors “not only have a right to feel good about promoting ESG, but that clear financial benefits can be expected.”
Released in mid-November, ESG Risk Factors in a Portfolio Context quantifies long-term ESG investment risk and its impact on investors’ strategic asset allocation. Specifically, the study aims to determine to what degree ESG factors influence equity investment risk.
Strategic asset allocation (SAA) has been described as the most important factor driving long-term portfolio returns. Estimates conclude that it accounts for up to 90% of portfolio risks, outweighing market timing and stock selection in importance. Yet, while much research has been done on ESG opportunities at the stock picking or company analysis level, little has been researched on the link between ESG and the risk/return profile of an entire portfolio. Other top-down SAA research has tended to be qualitative and focused on one element within the ESG acronym, usually the environmental as it relates to climate change.
The methodology of the study is distinguished by two distinct parts. The first is a search for a suitable risk factor with a valid data source for each component in the ESG acronym. After modeling, the E, S and G risk factors were integrated in stochastic capital market scenarios influencing equity returns over a 20-year horizon. The second part was the portfolio analysis itself, which was based on a comprehensive optimization framework that revealed efficiency gains due to ESG considerations.
In the study, the environmental risk factor was modeled on CO2 emission rights spot price change. The social risk factor approximates the return impact of employee sick days to business costs. Corporate governance ratings were used to quantify the impact of such factors on equity returns.
The impact of each factor on equity risk was analyzed using two groups of companies. In the “positive ESG Equity” cluster (+ESG), it is assumed that management is aware of ESG risks and tries to mitigate them proactively. The “negative ESG Equity” cluster (-ESG) consists of companies that ignore ESG risks. The underlying assumption was that ESG factors do not have an expected (positive or negative) return on equity but only drive investment risk.
Results revealed that ESG factors have a significant impact on risk and offer important opportunities to achieve efficiency gains. As a risk metric, a downside risk measure, the Conditional Value at Risk (CVaR) at 95%, was used. CVaR shows the average return (per annum) incurred in the 5% worst cases of the investment. For +ESG Equity, the CVaR is estimated to be -27%. For a global equity investment that roughly equals an average ESG Equity investment, the CVaR 95% is estimated to be -36%.
This study is innovative on at least two counts. Taking a quantitative approach, it explores uncharted territory by clearly making the link between portfolio asset allocation and relevant ESG criteria, an area not traditionally covered by SRI research. The study also moves the debate forward regarding the materiality of ESG criteria. David Diamond, co-head of SRI, Allianz Global Investors, FranceTo examine the potential for optimization, different portfolios and starting allocations in equity were analyzed. The study commences with a portfolio invested 30% in global equity and the remainder invested in government bonds and cash.
An allocation into +ESG Equity offers significant efficiency gains. At the same level of expected returns, the investor can reduce the CVaR by approximately one-third. Alternatively, the investor could enhance the expected return at similar levels of expected risk.
As an example, the portfolio including +ESG Equity shows an expected average nominal return 0.3 percentage points higher compared to the reference portfolio. According to the study, “the effects are even stronger when comparing portfolios where the equity allocation is higher.”
So far research on ESG has mainly focused on ESG-compliant equity investments from a bottom-up investment process perspective. There exists no systematic, long-term quantitative analysis explicitly examining ESG-derived risk factors and their portfolio impact. So the results of the risklab study are intriguing. After all, they arrive at a period of financial crisis when many investment strategies and products implementing ESG concepts have suffered as much as conventional equity investments.
Many institutional investors, in particular large European pension funds and endowments, have in recent years adopted ESG investment strategies. However, industry surveys reveal uncertainty among professionals about the risk/return effects of ESG investing.
This uncertainty is increased by the often contradictory results generated by research. For example, a recent research paper (EDHEC, December 2008) showed that none of the 62 funds examined managed to produce both positive and significant alpha (outperformance) over a six-year period.
However, a follow-up study by Altedia Consultants in 2009 analyzing more than 200 SRI funds over a three-year period found that best-in-class funds performed broadly in line with market indices and their own benchmarks. In addition volatility of best-in-class funds was noticeably lower than indices during the period.
Inside the methodology
To calibrate risk sensitivities along +ESG and -ESG Equity with respect to the three risk factors, risklab applied the GICS industry sector breakdown. In particular, sector weightings using relative carbon footprint, staff costs per sales data and corporate governance ratings were applied. For all data, specialist providers were selected via due diligence and data sources cross-checked by experts.
The relative weighting between economic, social and governance risk factors is equal. In this case, consistency was cross-checked with the results of the SRI Navigator analysis by the equity research team of Société Générale and expert discussions.