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Fine-Tuning ESG Risk Using Multi-Asset Portfolio Construction

Demand for environmental, social and governance (ESG)-related investments has surged in recent years. Given the very different ESG-related investments and risks inherent in the available asset classes, the best way to integrate ESG considerations into multi-asset portfolios is less clear.

How much ESG risk reduction can investors achieve through asset allocation alone? We answer that question by demonstrating the return and diversification consequences of reducing ESG risk using asset allocation. The analysis shows we can modestly reduce risk with limited asset substitution and a slight compromise on return potential.

More significant ESG risk reduction, however, requires more severe asset class substitution and return give-up. Ultimately, we conclude that the most effective way to reduce ESG risk is through a holistic approach that combines asset allocation and manager selection.

Focused on Equity Allocation 

We created a model portfolio with volatility (traditional risk) comparable to a typical 60/40 balanced portfolio for this study. Our work focused only on the equity allocation, arguably the key driver of multi-asset portfolio return. The equity universe also has much broader ESG coverage than fixed income, with ratings widely available across capitalization ranges, styles and geographies.

We varied the desired ESG risk exposure and evaluated the resulting return penalty to a series of efficient portfolios. Since our goal was to show what asset allocation alone can do to mitigate ESG risk, we didn’t adjust further to account for sector allocation, geography and security selection.

Modest Allocation Changes Helped Reduce ESG Risk

We found that it is possible to reduce our equity portfolio’s ESG risk using asset allocation alone. In other words, without considering the ESG risks/benefits of any individual securities we were able to reduce our model portfolio’s ESG risk without giving up much return potential. In our example, a 10% ESG risk reduction—considered a reasonable portfolio construction goal—is achievable with a modest return give-up. However, the allocation changes aren’t inconsequential. And more significant ESG risk reduction undoubtedly requires more substantial allocation changes.

Figure 2 details these varying allocations. We see a significant preference for real estate investment trusts (REITs) over other equities and a shift from value equity into core and then growth as we ratchet down ESG risk. This reflects the more attractive ESG risk profiles of REITs and U.S. large-cap growth equities relative to value. We also see that a position in emerging markets equities (EME) is maintained until the ESG risk-reduction goal becomes quite high.

So, while EME looks unattractive in ESG terms in isolation, its return profile is compelling relative to its ESG risk. The result is that for all but the most ESG risk-averse portfolios, EME may provide an attractive trade-off for the exposure taken.

Figure 2 | Asset Allocation Can Help Fine-Tune ESG Risk for a Given Level of Volatility Hypothetical Allocation Changes in an Equity Portfolio

Source: American Century Investments. Note: Hypothetical illustration. Results not intended to represent any actual investment strategy. Past performance is no guarantee of future results. The graphic depicts a hypothetical equity allocation in an efficient 60/40 stock/bond portfolio, created using American Century’s capital market risk and return assumptions1 and Sustainalytics ESG asset class scores.2 This graphic is meant to illustrate the type and degree of changes required to reduce portfolio ESG risk using asset class substitution in the equity portion alone. 

Significantly Reducing ESG Risk Required Diversification and Return Trade-Offs

Figure 3 shows the trade-off in return versus ESG risk for a given level of volatility (standard deviation). The figure illustrates the extent to which reducing ESG risk using asset allocation strategies alone penalizes portfolio return.

Notably, the trade-off is nonlinear. Initially, a modest reduction in ESG risk allows some asset substitutions, such as introducing REITs in place of other equities, that carry little return penalty. Specifically, we see that we can realize a 10% improvement in ESG risk with relatively modest allocation changes while giving up only 11 basis points of return. This is designated Portfolio B.

However, as we seek to lower ESG risk more meaningfully, we must introduce less favorable trade-offs, such as forcing out mid-cap equity and EME. As a result, the efficient frontier in Figure 3 steepens, penalizing return at an increasing rate as we lower ESG risk (see points designated Portfolios C and D). The shape of this curve highlights the extent to which naïve attempts to reduce ESG risk through asset allocation alone may be undesirable. 

Figure 3 | Reducing ESG Risk Through Asset Allocation Requires a Return Trade-Off Portfolio ESG Risk/Return Profile (Diversified Equity Portfolios, Standard Deviation Held Constant)

A → B: 10% ESG improvement 11 bps return reduction
A → C: 18% ESG improvement 29 bps return reduction
A → D: 23% ESG improvement 41 bps return reduction

Source: American Century Investments. This hypothetical illustration is not intended to represent any actual investment strategy. Past performance is no guarantee of future results. The illustration depicts a hypothetical equity allocation in an efficient 60/40 stock/bond portfolio, created using American Century’s proprietary capital market risk and return assumptions and Sustainalytics ESG asset class scores.

A Holistic Approach Is Preferable

The implication is clear—asset allocation presents opportunities to fine-tune portfolio-level ESG risk. We believe we can modestly reduce ESG risk through allocation adjustments with comparatively little return penalty. But more aggressive ESG risk reduction requires increasingly severe asset substitution and return penalties. As a result, we believe an integrated approach that includes individual security and manager selection is the best way to reduce ESG risk.

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1

The vast majority of American Century's investment strategies are subject to the incorporation of ESG factors into the investment process employed by each strategy's portfolio managers. When portfolio managers incorporate Environmental, Social and Governance (ESG) factors into an investment strategy, they consider those issues in conjunction with traditional financial analysis. When selecting investments, portfolio managers incorporate ESG factors into the portfolio's existing asset class, time horizon, and objectives. Therefore, ESG factors may limit the investment opportunities available, and the portfolio may perform differently than those that do not incorporate ESG factors. Portfolio managers have ultimate discretion in how ESG issues may impact a portfolio's holdings, and depending on their analysis, investment decisions may not be affected by ESG factors.

ESG Definition:

  • ESG Integrated: An investment strategy that integrates Environmental, Social and Governance ("ESG") factors aims to make investment decisions through the analysis of ESG factors alongside other financial variables in an effort to deliver superior, long-term, risk-adjusted returns. The degree to which ESG integration impacts a portfolio's holdings may vary based on the portfolio manager's materiality assessment. Therefore, ESG factors may limit the investment opportunities available, and the portfolio may perform differently than those that do not incorporate ESG factors. Portfolio managers have ultimate discretion in how ESG issues may impact a portfolio's holdings, and depending on their analysis, investment decisions may not be affected by ESG factors.

2

Sustainalytics ESG Risk Ratings

Sustainalytics ESG Risk Ratings are designed to identify and understand financially material ESG risks at the security and portfolio level. To this end, the ESG Risk Rating captures an issuer’s exposure to material ESG issues (MEIs) and an issuer’s management of those risks. Each company’s ESG Risk Rating score is the sum of the unmanaged risk for each of its MEIs. The more of this risk that is unmanaged, then the higher the ESG Risk Rating score. An issuer’s ESG Risk Rating score is assigned to one of five ESG risk categories: negligible, low, medium, high, and severe. Each category captures a level of material financial impacts driven by ESG factors. For more information go to sustainalytics.com.

American Century Investments Capital Market Assumptions

For each asset class, American Century develops a set of assumptions for return, risk, and correlation. Because asset class returns and relationships are ultimately grounded in economic fundamentals, we forecast over the equivalent of a complete economic and market cycle. We arrive at our return forecasts through various modeling techniques, such as a classic valuation approach, a risk-premium approach, and an historical risk and return analysis. In addition to this quantitative process, we employ a qualitative review, recognizing that there are elements that can’t be easily captured by a quantitative process. Further, the quantitative models require forecasting various inputs, which again may contain qualitative elements.

References to specific securities are for illustrative purposes only, and are not intended as recommendations to purchase or sell securities. Opinions and estimates offered constitute our judgment and, along with other portfolio data, are subject to change without notice.

International investing involves special risk considerations, including economic and political conditions, inflation rates and currency fluctuations.

Alternative mutual funds that hold a variety of non-traditional investments also often employ more complex trading strategies than traditional mutual funds. Each of these different alternative asset classes and investment strategies have unique risks making them more suitable for investors with an above average tolerance for risk.

Diversification does not assure a profit nor does it protect against loss of principal.

Past performance is no guarantee of future results. Investment returns will fluctuate and it is possible to lose money.

Mutual fund investing involves market risk. Investment return and fund share value will fluctuate. It is possible to lose money by investing in mutual funds.

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