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How smarter ESG integration can preserve your free lunch
David Barron and Jennifer Shering, Legal & General Investment Management
The first generation of ESG strategies excluded whole sectors from investors’ portfolios. Such approaches are still widely used, but inves- tors may be underestimating their impact on portfolio diversification.
Some investors value the peace of mind that comes from diversification, through owning different assets so that risks aren’t overly concentrated.
Meanwhile, as many institutional investors are recognising a “climate emer- gency” and are under pressure to seek sustainable investment solutions, there is increasing demand for reflecting environmental, social, and govern- ance (ESG) considerations in portfolios. But for some investors, excluding fossil fuels could mean excluding the entire energy sector. In these terms, the objectives of diversification and of avoiding particular eco- nomic sectors because of ESG criteria appear contradictory. We investigated this apparent conflict in order to quantify more accurately the relationship between negative screens and portfolio diversification in equities: put simply, are they friends or foes?
We compared the correlation of each sector in the MSCI World to that index to show the long-term diversification impact of each sector.
Some sectors, such as consumer staples (including tobacco), healthcare and utilities, have consistently been diversifiers. However, correlations are dynamic, not static, and can switch unpredictably. Excluding sectors can deprive investors of diversifying assets unexpectedly, exposing them to greater risk.
Weight watchers When sectors are omitted from a market cap portfolio, how is their index weight redistributed among the other sectors? This could create unintended risks: a portfolio could end up with a higher beta than desired, or may not offer the required market performance.
When energy is excluded, the largest overweights have tended to be consumer discretionary, financials and technology. The overall effect of rebalancing away from energy and into these three sectors is likely to result in above-average beta. Furthermore, these sector weights will vary over time. We have focused on global developed market cap exposure, with around 1,000 securities across more than 20 countries. For regional allocations, the impacts of reweighting can be even more pronounced: in UK equities, three energy stocks from just two issuers make up more than 15% of the FTSE 100. Exclude these, and the redistribution effect could create an overweight of almost four percentage points to financials.
26 November 2019 portfolio institutional roundtable: Responsible investing
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