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Table 2: Average sector overweights in MSCI World excluding energy (%), 31.01.1995 to 28.06.2019


Materials Industrials


Consumer Discretionary Consumer Staples Healthcare Financials


Information Technology Telecoms Utilities


0.53 0.96 1.03 0.81 0.94 1.84 1.07 0.43 0.36


Source: LGIM, MSCI, Bloomberg


financials have been highly correlated to the MSCI World index for long periods, but this has changed at inflection points rather than staying fixed. Correlations can switch unpredictably at key moments and so excluding sectors can deprive


investors of diversifying assets


unexpectedly or expose them to greater risk if the retained sectors converge in periods of market stress.


WEIGHT WATCHERS


This possibility prompts another question: when sectors are omitted from a market- cap portfolio, how is their index weight redistributed among the


other sectors?


This can obviously lead to unintended risk exposures if it concentrates a portfolio in sectors that are either more or less correlated to the index. In the former case, the portfolio could end up with a higher beta than desired; in the latter scenario, the portfolio may not offer the required market performance. As Table 2 displays, when energy is excluded the largest overweights have tended to be to consumer discretionary, financials and technology. Comparing this with Table 1, we see that the overall effect of rebalancing away from


energy and into these three sectors – each of which has a relatively high correlation to the MSCI World index – is likely to be an equity portfolio with an above-average beta. The consistent diversifiers – con- sumer staples, healthcare, and utilities – receive more modest upgrades. Again, though, we have to reiterate that these weights will vary through time – not always to the investor’s advantage. The overweight to financials, for instance, reached its zenith just in time for the financial crisis. Turning to the present day, the most sig- nificant overweight in the MSCI World excluding energy is


information


technology at 0.98%. This additional expo- sure to tech stocks has important conse- quences for investors, not least for those who have already chosen to overweight technology elsewhere in their portfolios. An additional point is that we have focused on global developed market-cap exposure here, which has well over 1,000 securities across more than 20 countries. For inves- tors thinking about regional allocations, the impacts of reweighting can be even more pronounced. In the UK equity space, for example, three energy stocks – from just two issuers – make up more than 15% of the FTSE 100. Exclude these and the redistribution effect can lead to an over- weight of almost four percentage points to financials within that adjusted index.


MATTER OF FACTOR We can also look at the factors – or risk premia – that the energy sector has contrib- uted over time. The decline in the oil price from 2014 clearly left energy heavily overweight the value factor, although this has moderated of late. This has led some to the erroneous presumption that such negative screens systematically underweight value.


This is not the case. Excluding energy in recent years has certainly left portfolios underweight the value factor, but not so long ago, quality and momentum were major forces in the energy index. Investors may have been willing to forgo value exposure over the past few years as that factor has underperformed, but would they have been so happy to minimise the quality and momentum factors under pre- vious market regimes? Although there isn’t a formally recognised dividend or income factor, we would also note that excluding energy – and tobacco – is likely to have impaired a portfolio’s yield through this period.


PORTFOLIO PERMUTATIONS With all this in mind, traditional negative screens may be most appropriate for inves- tors who are obliged to avoid certain sec- tors. But other investors may be able to pre- serve the diversification benefits from sectors like energy without sacrificing their ESG criteria by integrating those criteria into their investment process in more nuanced ways. At Legal & General Investment Manage- ment, we believe ESG scoring gives us a framework for engaging the companies in which we invest and also allows us to tilt portfolios to reflect ESG criteria while maintaining diversification.


Important notice Past performance is no guarantee of future results. The value of an investment and any income taken from it is not guaranteed and can go down as well as up, you may not get back the amount you originally invested. The Information in this document (a) is for information purposes only and we are not soliciting any action based on it, and (b) is not a recommendation to buy or sell. securities or pursue a particular investment strategy; and (c) is not investment, legal, regulatory or tax advice. Legal & General Investment Management Limited. Registered in England and Wales. No. 02091894. Registered Office: One Coleman Street, London, EC2R 5AA. Authorised and Regulated by the Financial Conduct Authority, No. 119272.


Issue 87 | October 2019 | portfolio institutional | 41


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