Portfolio managers who wish to focus on particular sustainability goals need data that measures specific company achievements within broad categories. A new white paper examines the creation of tailor-made portfolios that prioritise sustainability.
- Many sustainability goals can be measured using granular environmental, social and governance (ESG) variables, but not all goals can be measured equally well.
- Custom-designed sustainability portfolios do not compromise on financial performance and in some cases outperform the benchmark.
- Compared with U.S. investors, EU investors have a greater interest in sustainability issues.
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The ESG investing world encompasses a wide range of issues such as climate change, social responsibility and gender/ethnic diversity in corporate governance.
A company or stock portfolio’s commitment to sustainability is often measured in relation to well-known ESG criteria, and data providers such as Refinitiv publish E, S and G scores for thousands of firms.
However, investing viewpoints differ. For example, some Dutch asset managers might like their investments to contribute to clean oceans and fresh water, given the long relationship of the Netherlands with water. Other managers may want to focus on gender equality or education.
Specific measurements of sustainability goals
With more than 450 Refinitiv ESG metrics available, is it possible to be that specific? The short answer is: yes. The longer answer is: it depends.
For example, the 17 UN Sustainable Development Goals (SDGs) include many ESG categories and variables that could reflect particular investment goals. Some are easier to measure than others.
The white paper analysis finds that seven are well-measurable, including “industry, innovation and infrastructure” and “climate action”.
Specific measurements can be used to judge companies’ achievements.
For instance, for the “gender equality” SDG, the variables for corporations include: females on the board, policy diversity and opportunity, targets for diversity and opportunity, female managers and the gender pay gap.
Tailored portfolios
So it’s possible to measure ESG criteria in detail, but how well do such tailored portfolios perform?
There are several ways, ranging from excluding badly performing companies to including only well-scoring ones, to select stock portfolios that perform well (and better than benchmark) in terms of tailor-made sustainability goals.
A manager must choose the sustainability goals carefully.
If the goals are “elimination of poverty” and “reducing CO2 emissions”, the investment portfolio cannot be optimised with respect to both, as achieving the two goals simultaneously is almost impossible in practice.
To evaluate the effect of the SDGs’ screening on portfolio performance, the analysis constructs and compares a number of portfolios based on the SDG scores and market capitalisation.
Portfolio construction
The core idea of the portfolio construction is that the analysis keeps the same sector allocation in the portfolios as the benchmark index, and then selects 10 percent of stocks by certain sustainability criteria within each sector.
In this way, the hypothetical portfolios mimic the same diversification as the benchmark, and thus compare performance between portfolios and the benchmark.
In all such suggested portfolio construction methods, the importance of sector diversification stands out, so well-diversified portfolios are constructed that are also superior in terms of sustainability goals.
If the manager doesn’t pay attention to sector diversification but only to SDG performance, the analysis shows there can be a significant sector tilt. For example, if stocks are selected only according to the performance on the “gender equality” SDG, then communications, energy, industrials, material and utilities sectors would be excluded.
When comparing the sustainability portfolios with such benchmarks as the S&P 500 and STOXX 600, the results show that SDG-based investment strategies do not necessarily lower performance. For example, an “exclusion” portfolio with respect to the “gender equality” SDG slightly outperforms the benchmark.
In Europe, the advantages of SDGs screening are more obvious. Almost all SDG-screened portfolios outperform the benchmark or are on par with it. In general, it shows that investors in Europe can take a more aggressive sustainability strategy than their U.S. counterparts.
