ESG in strategic asset allocation

As investors continue to examine all aspects of ESG, a question that will increasingly crop up, is the impact that improved ESG profiles could have on portfolios as a whole.

In a nutshell:

• How might a Strategic Asset Allocation (the long run target weights to different asset classes) change given an investor’s desire to turn their investments a deeper shade of green?
• First, one must quantify what one means by 'improving the ESG profile of a portfolio'
• Second, would be to keep all the asset class weightings the same, but instead of using traditional market cap weighted indices, to use ESG indices in their place
• A third option of course would be to try both at the same time

1. A commitment to ESG and SAA thinking

1.1 Identifying the role ESG may play in portfolios

As a member of the Institutional Investors Group on Climate Change (IIGCC), DWS has committed to thinking about this very question of how might a Strategic Asset Allocation (the long run target weights to different asset classes) change given an investor’s desire to turn their investments a deeper shade of green? Indeed, the Paris Alignment Initiative—an IIGCC work stream—is charged with helping to try to solve the issue of ensuring that detailed ESG and carbon footprint metrics become standard features of investor’s portfolios.

In trying to do that, the group uncovered a significant gulf in the literature on the strategic role that ESG will play in portfolios. And it was this gulf that spurred researchers at DWS to write two related papers on this topic: ESG in Strategic Asset Allocation (SAA): A practical implementation framework, and ESG in Strategic Asset Allocation: The 2022 Update.

2. Quantify what improving the ESG profile means for a portfolio

2.1  Three principal metrics

First, one must quantify what one means by 'improving the ESG profile of a portfolio'. And, whilst that will almost certainly mean different things to different people, the papers hone in on three principal metrics. The first is a reduction in carbon footprint, the second is the removal of securities that achieve an E or F rating according to the firm’s proprietary ESG engine, and the third is the over weighting of those that achieve an A or B rating.

The papers note that there are two main ways in which one could take a 50:50 global equity and bond portfolio (or, in the later iteration, a portfolio with 10% in Alternatives too), and try to improve its ESG profile. The first method would be to start with the original portfolio, but to try changing the sector, region, or asset class weights so that the portfolio has an improved ESG rating but is still sufficiently similar to the original portfolio for the investor’s tastes.

2.2  Asset class weighting and index considerations

The second way would be to keep all the asset class weightings the same, but, instead of using traditional market cap weighted indices, to use ESG indices in their place (and a third option of course would be to try both at the same time).

So, how do the two approaches look, and what, ultimately, is the price that an investor pays when they seek a greener profile? Well, in the first instance, it turns out that a reasonable outcome is achievable merely by changing the weightings in a traditional SAA. For example, according to DWS’ calculations, the carbon footprint of a global portfolio can come down by around –7%, at the cost of 0.25% of tracking error (TE).

For those willing to stomach a little more deviation from the benchmark, carbon intensity could be lower, by around –32%, at a tracking error of 1.00%. Keep in mind that this is simply by re-weighting traditional indices, nothing more.

However, the researchers conclude that an arguably more powerful result can come from using ESG indices in the stock and bond allocations, instead of traditional ones. Now, for a tracking error of around 0.88% on average (see Figure One), an investor can potentially achieve a carbon reduction of more than –44%, and, by the team’s reckoning, a slightly higher Sharpe ratio as well.

Figure One: The tracking error of an ESG allocation versus a traditional allocation

3. Application of both approaches

Finally, applying both approaches at the same time, it was possible to benefit even more. In this last case, a carbon reduction of –50% was achieved for the same 0.25% TE witnessed before. And, whilst recognizing the potential added complexity of pulling multiple levers at the same time, it does seem that it’s an approach worth considering given its apparent ability to give investors more of what they want, for less of what they don’t. Of course, investors will not only need to focus on the risk side of the equation, they will want to consider the potential impact that any of these changes might have on the return side too. Like so many things in finance, it ultimately comes down to a trade-off, and not an entirely simple one, between the three legs of the new financial calculus—return, risk, and responsibility.

So, the bottom line is that there are several different ways to improve the ESG profile of a Strategic Asset Allocation. It can be done simply through changing the relative sector, country, and asset class weights of one’s original portfolio, it can be done via switching to dedicated ESG indices, and it can be achieved via a combination of both. And, of course, it should not be lost on anyone that what matters from an ESG improvement standpoint will very much change depending on an individual’s preferences, values, and goals.

The team do not claim to have solved these issues, merely to have made a first step in highlighting them and thinking about them in a practical way. It is the type of engagement that all investors must ultimately undertake because, whatever one’s views on ESG, the topic is simply too big, and too important, to ignore.

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