How smarter ESG integration can preserve your free lunch

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. 

Investors may recently have been willing to forgo value exposure because of underperformance, but would they have wanted to minimise quality and momentum factors in previous market conditions?

Portfolio permutations

In summary, traditional negative screens may be appropriate for investors who must avoid certain sectors. But others could preserve diversification without sacrificing their ESG criteria, by integrating those criteria into their investment process in more nuanced ways. The exploration of innovative and effective ways to incorporate ESG is the focus of our current “Friend or Foe” research. 

At Legal & General Investment Management, we believe ESG scoring provides a framework for engaging the companies in which we invest, and also allows us to tilt portfolios to reflect ESG criteria while maintaining diversification.

By David Barron and Jennifer Shering, Legal & General Investment Management

Important notice

Past performance is no guarantee of future results. The value of an investment and any income taken from it is not guaranteed and can go down as well as up, you may not get back the amount you originally invested. The Information in this document (a) is for information purposes only and we are not soliciting any action based on it, and (b) is not a recommendation to buy or sell

securities or pursue a particular investment strategy; and (c) is not investment, legal, regulatory or tax advice. Legal & General Investment Management Limited. Registered in England and Wales

No. 02091894. Registered Office: One Coleman Street, London, EC2R 5AA. Authorised and Regulated by the Financial Conduct Authority, No. 119272.

This is a Legal & General Paid Post. The news and editorial staff of the Financial Times had no role in its preparation