This article is a part of NordSIP Insights – Handbook – “Systematically Sustainable”.
As demand for sustainable investment options continues to grow, understanding the integration of ESG factors into indices is paramount to investors and fund managers looking to replicate the performance of these indices.
Recognising the demand for a more detailed understanding of the underlying index and portfolio-building processes, UBS has highlighted the challenges and opportunities surrounding the development of equity strategies that integrate sustainable factors.
Issues in Index Replication:
Liquidity, Turnover, Corporate Events and Valuation
While most investment strategies seek to achieve a well-defined and measurable risk and or return target, sustainable investing tends to focus on multiple goals. The focus is on both long-term returns as well as on several ethical considerations, which creates modelling difficulties arising from data coverage, quality and standards.
According to UBS’s Ian Ashment, Boriana Iordanova, Rodrigo Dupleich and Xiaochen Zhao, the implementation of index portfolios that combine sustainability factors with traditional risk premia factors involves timely, detailed, precise and pragmatic considerations of liquidity, turnover, corporate events and valuation.
Liquidity concerns arise from the fact that the underlying thematic focus of the index tends to concentrate the portfolio around fewer stocks that may be less liquid. According to the UBS analysts, the higher liquidity of the MSCI World index compared to the MSCI World SRI and the MSCI ACWI ESG Universal Index illustrates that point quite clearly.
Turnover issues are another concern during the construction and maintenance of index equity portfolios tracking sustainable indices. Investors must carry out a balancing act between minimising tracking error and index imbalances, while at the same time limiting transaction costs, such as those associated with turnover. Again, the facts suggest that the MSCI SRI and ESG indices have a turnover four to six times larger than the MSCI World index.
Index providers typically follow specific rules for the way that different indices treat “corporate events”. The main difference in treatment between standard market cap and sustainable indices is in the case of spin-offs, mergers, takeovers, and rights issues. While these events require little or no action in market cap indices, they may result in far more significant trading in sustainable indices. The complexity of these rules requires managers to maintain an ongoing dialogue with index providers to ensure it is fully aware of the correct treatment of corporate events within the indices.
According to UBS’s quantitative analysts, valuation analysis should be one of several tools used when examining ESG/SRI strategies, but not the only one. As sustainable indices seek to capture better-quality companies with long-term sustainable prospects, it is not surprising that UBS finds four global ESG/SRI indices trading at a premium compared to the market cap index.
Applying ESG/SRI Exclusions to Rules-Based Portfolio
Another approach to the integration of ESG/SRI factors into a rules-based portfolio is the use of such factors to determine which stocks should be excluded. While the effectiveness of exclusions is debatable, its popularity is a sign of how easy it is to use them to align strategies with investors’ ethical policies.
There are two potential approaches to implementing exclusion lists depending on whether the exclusions apply to the index as well as the portfolio tracking it. In the first approach, stocks/ sectors are excluded both from the index and from the portfolio. Therefore, the portfolio tracks a modified version of the original index, pretending these stocks do not exist. The approach is simpler and more transparent than its alternative, which makes it very appealing. Excluding stocks from the index and the portfolio allows the management of the portfolio against the modified index.
The second approach keeps the original index unchanged, but stocks are excluded from the portfolio by using stratified sampling or optimisation techniques to minimise tracking error. The resulting portfolio also tends to have broader representation compared to the resulting portfolio in the first approach. However, the approach suffers from various problems, according to UBS’s analysts. Performance attribution is more complicated and made opaque by complex sampling or optimisation techniques. Moreover, the fact that these models typically ignore ESG factors undermines the risk reduction achieved by an optimiser. Finally, the use of an optimiser might also generate counterintuitive portfolios. The UBS quantitative analysts discuss the example where a client’s exclusion list containing the largest tobacco producers could lead the optimiser to increase the weights of the smaller tobacco producers to reduce the sector-level deviations and minimise the tracking error. The resulting portfolios might actually end up increasing the portfolio’s exposure to tobacco.
Constructing custom rules-based portfolios via Tilts
One of the emerging themes in sustainable investing is the increasing diversity of approaches to integrating sustainable factors in rules-based portfolios. The emerging panoply of methods is motivated by the heterogeneity of investors’ time horizons, risk tolerance, beliefs relating to sources of risk premia, different ethical considerations. There are also different long-term perceptions about risk-returns as exemplified by the opportunities and challenges presented by the energy transition and data considerations. Finally, investor awareness and preferences for implementing sustainable factors are also important drivers of the increasing diversity of approaches, motivating the use of exclusions, tilts, and engagement across different strategies.
The use of tilts has proved particularly useful due to its flexibility and the nuanced approaches it allows. The UBS specialists describe two instances where the asset manager applied different versions of tilts to sustainable investment portfolios.
Tilting Based on Climate Awareness and Engagement
The first example considers the incorporation of climate-related factors in a portfolio to construct the UBS Climate Aware Rules-Based Global Equity Strategy. This strategy focuses on achieving the goals of the 2015 Paris Agreement through a forward-looking rules-based approach that continues to invest in carbon-emitting companies. The strategy has a dual focus. First and foremost, it supports companies that are well-positioned to benefit from the energy transition and those that are developing new technologies necessary for the transition. UBS applies a tilt that allows it to focus on companies that are aligned with the 2°C Scenario of the Paris Agreement. Compared with the FTSE Developed index, the UBS Climate Aware strategy achieves 64% more exposure to renewable energy companies, a 25% decrease in Scope 1 CO2 emissions, 48% less exposure to coal energy and a 30% reduction of its exposure to (decreasing) fossil fuel reserves.
However, the strategy also engages with companies that appear to be less well-positioned to benefit from the energy transition. Here the asset manager is keen to highlight the uncertainties of climate change. Its approach reflects the long-term journey that the transition to a low carbon economy requires and the fact that while the destination is reasonably well defined, the journey there is more uncertain. To overcome the challenges posed by uncertainty, the asset manager focuses on a clear engagement strategy and active voting approach. It encourages companies to report carbon emissions data, design and report on the progress of clear plans and goals for reducing emissions and comply with best practice in reporting along the lines of the TCFD recommendations. Finally, it also recommends the inclusion of scenario testing and reporting of the implications of this exercise in companies’ annual reports.
Tilting based on Governance Scores
The second case describes the integration of governance scores in a portfolio tracking the MSCI ACWI Index. Concerns over governance have been at the heart of investment strategies since the 1992 Cadbury report on Financial Aspects of Corporate Governance, and subsequent research has shown that good governance can lower companies future idiosyncratic risk.
UBS’s quantitative analysts explain that there is a range of challenges to building such a strategy. While the broad range of data sources creates an opportunity to capture governance factors, the underlying portfolio model needs to be able to isolate governance issues from other variables. One challenge is to avoid the unintended bias towards developed markets, as those companies tend to score higher on governance measures.
UBS designed two governance-based strategies that show many appealing features. Distinguished by the level of governance score increase (20% vs 40%), the return of both approaches outperformed the MSCI ACWI Index by 0.40%, with minimal increases in reported risk metrics. Statistical analysis shows that the excess returns generated by the governance-tilted strategy can be attributed to the integration of governance scores, even when accounting for Barra risk factors.
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