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How smarter ESG integration can preserve your free lunch
David Barron Jennifer Shering
The first generation of ESG strategies excluded whole sectors from investors’ portfolios. Such approaches are still widely used, but investors may be underestimating their impact on portfolio diversification.
We know some investors value the peace of mind that comes from owning lots of dif- ferent assets in their portfolios, so their risks aren’t too concentrated in any one area. They want diversification, in other words. But equally we know that some investors want to reflect environmental, social, and governance (ESG) considerations in their portfolios. For some, that can mean exclud- ing fossil fuels – typically meaning the entire energy sector – from their portfolios.
In a sense, these two desires – building a diversified portfolio and avoiding vast swathes of the economy – are mutually exclusive. We wanted to investigate this apparent con- flict in order to quantify more accurately the relationship between negative screens and portfolio diversification in equities. Put simply, are they friends or foes?
SECTOR INSPECTOR
As a starting point, we looked at the correla- tion of each sector in the MSCI World index
to that parent index. This gave us a long- term picture of the diversification
divi-
dends yielded by each sector, as illustrated in Table 1. We see here that some sectors have consist- ently been diversifiers. These include con- sumer staples (which encompasses tobacco,
of course), healthcare and
utilities. However, we must remember that correla- tions between sectors are dynamic, not static. For example, energy was a diversifier through the 2000s; technology and then
Table 1: Average five-year rolling correlations between MSCI World index sectors, 28.02.1995 to 28.06.2019 World
World Energy
Materials Industrials
Consumer Discretionary
Consumer Staples
Healthcare Financials
Information Technology
Telecommuni- cations
Utilities Real Estate 1
-0.0910 0.2006 0.1596
0.1254 -0.6149
-0.5208 0.3467
0.3367 -0.1780
-0.5743 -0.0263
1
0.3929 0.0584
-0.3466 0.0688
-0.0221 -0.1361
-0.3499 -0.1672
0.2101 0.0139
1 0.4161 -0.0201 -0.1520
-0.2678 0.0765
-0.2506 -0.3375
-0.1156 0.1668
1 0.2155 -0.1195
-0.2206 0.1784
-0.1763 -0.4222
-0.1435 0.1166
1 -0.2440
-0.3040 -0.0030
0.2161 -0.1395
-0.3542 -0.0252
1
0.6284 -0.1080
-0.5831 0.0543
0.6302 0.2161
1 -0.1208 -0.4393 0.0738
0.4568 0.0411
1 -0.3275 -0.3754
-0.1814 0.2681
1 0.1218
-0.5031 -0.3128
1
0.1507 -0.2511
1 0.2248 1 Source: LGIM, MSCI, Bloomberg Energy
Materials Industrials Consumer Disc
Consumer Staples
Health- care
Financials IT Telecoms Utilities
Real Estate
40 | portfolio institutional | October 2019 | issue 87
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