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However, the tilting approach also eliminates significant numbers of poorly rated companies, owing to their attempts to identify and allocate to factor ESG champions. The key problem with this option is set- ting the exclusion level. Should it be a fixed quantity or a percentage, by region or sector? This depends on the portfolio’s objectives.
Option 3: Top down: tilt at the end or combining portfolios This method keeps ESG considerations and factor scores separate until the final stage of the portfolio construction process. A factor portfolio is created, then the factor weighting of each stock is adjusted according to its ESG score.
The second option is to create an independent ESG-integrated portfolio and combining this with the factor-level portfolio afterwards. Attribution for the pure factor portfolio is possible in both, but extremely easy in the latter option.
This approach has the additional benefit of being able to control the exposure to factors and ESG considerations independently of each other simply using an allocation of capital. The downside of this approach is that it likely has the highest factor cancellation effect, as the two portfolio segments are managed separately. This will result in inconsistent exposures over time as the factor portfolio rebalances will not consider whether or not they are allocating to strong or weak ESG-scoring companies – and vice versa.
A fair-weather friend? Investors are faced with a number of choices: if embracing the drawbacks of competing investments is worth the simplicity (when managing a separate ESG-integrated portfolio); if excluding poor performers (and enjoying the purity of a factor construction) compensates the work required to define the ‘laggards’, and if the bottom-up approach is worth the potential concentration risk.
If current trends are any indication, we can expect to see a lot of all three.
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September 2019 portfolio institutional roundtable: Factor investing 25
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