The first generation of ESG strategies excluded whole sectors from investors’ portfolios. Such approaches are still widely used, but investors may be underestimating their impact on portfolio diversification.
The first generation of ESG strategies excluded whole sectors from investors’ portfolios. Such approaches are still widely used, but investors 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 emergency” and are under pressure to seek sustainable investment solutions, there is increasing demand for reflecting environmental, social, and governance (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 economic 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?
Sector inspector
We compared the correlation of each sector in the MSCI World index to that index to show the long-term diversification impact of each sector.
Table 1: Average five-year rolling correlations between MSCI World index sectors, 28.02.1995 to 28.06.2019
Source: LGIM, MSCI, Bloomberg
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 to consumer discretionary, financials and technology. Compared with Table 1, 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 over 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 over 15% of the FTSE 100. Exclude these, and the redistribution effect could create an overweight of almost four percentage points to financials.
Matter of factor
We also looked at the factors (risk premia) that the energy sector has contributed over time.
The decline in the oil price from 2014 left the energy sector heavily overweight the value factor (although this has moderated). This led some to presume that negative screens systematically underweight value, but this is not the case. Recently, excluding energy has certainly left portfolios underweight value, but not so long ago, quality and momentum were major forces in the energy index.
