Environmental, social and governance-based investing has surged in popularity in the past decade. A common approach is to apply an ESG screen to existing holdings, or to integrate ESG criteria directly into the analysis and selection of stocks. The objective is usually to improve the ESG-rating of a portfolio overall.

While this is a worthy approach, often investors have little understanding of the impact of introducing ESG criteria on their investment opportunity set, or how the risk and return characteristics of their portfolio are affected. Style or factor tilts can emerge without them knowing. Quantitative techniques can be used to evaluate and manage these effects to enable investors to achieve their sustainability and financial goals.

In the first section of this paper we show that the introduction of ESG criteria to an equity portfolio gives rise to implicit secondary market factor exposures when compared with a broad market index – an often overlooked result of socially responsible investing. For example a portfolio may end up with a large cap bias, or be overly exposed to European countries.

It is important for asset owners and portfolio managers alike to be aware of these secondary exposures, since they can alter the risk and performance metrics of a portfolio if they are not actively managed or neutralised.

To investigate the effects of ESG integration further, the second part of this paper is a case study where we build a portfolio that tracks the MSCI World index while applying a best in class ESG screening tool, specifically the DWS ESG engine. One way to do this is to combine ESG tilts with an alpha generating active strategy. This allows stocks to be screened in a way which maximizes risk adjusted returns. We do this by using our own in-house active quantitative strategy.

The results are significant. We show that increasing the ESG tilts to passive portfolios requires investors to bear a greater tolerance to tracking error. Combining ESG screens with an active approach however can add value by producing higher risk adjusted returns while fulfilling investors’ ESG requirements. For a given investor, the ‘right’ parameters may be established through the use of quantitative analysis and simulation.

One catch seems to be that as the ESG tilt is increased above a certain level, the information ratio of these active portfolios drops off more rapidly – in other words risk adjusted returns begin to decline when combining alpha maximising strategies with higher ESG tilts although the information ratio remains positive. The combination of alpha and ESG investment objectives requires a higher active risk tolerance from investors.

These simulations therefore provide a framework for investors to think about the relationship between their sustainability and risk return objectives. This raises the question of whether standard market indices are adequate benchmarks given the ESG impact on the investible universe.

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