From Exclusions to Returns: Evaluating the Financial Risks of Responsible Investing

Focusing on nearly 500 indices from developed Europe and the United States, the authors provide a detailed look into how different levels of exclusions, from mild to stringent, can shape financial outcomes for institutional investors.

Unpacking ESG Exclusions: An In-Depth Study

Exclusion is a widespread method in sustainable investing, but its effects on portfolio performance and risk profiles remain debated. To remedy the lack of consensus on the ESG exclusion criteria, the authors – elaborating on their previous paper (1) –  built three ESG screens based on different approaches and analyzed their impact on a large sample of indices.

The first, termed the “Consensus Screen,” relies on widely accepted ESG exclusion criteria prevalent among asset owners, targeting industries such as controversial weapons or tobacco industries. These criteria are based on a review of ESG investment policies applied by the largest asset managers in the world.

The second, known as the “PAB Screen,” aligns with the minimum standards for EU Climate Transition Benchmarks and for EU Paris-aligned Benchmarks. It therefore targets climate-related sectors such as the oil and gas industries, while still addressing major non-climate issues such as tobacco and violations of United Nations Global Compact (UNGC) principles.

Finally, the “SDG Screen” adopts a more ambitious stance, eliminating any company that negatively contributes to one of the 17 United Nations’ Sustainable Development Goals (SDGs).

The analysis revealed that the application of these ESG screens resulted in average excluded weights of 9%, 10%, and 58% for the consensus, PAB, and SDG screens, respectively, on a sample of 128 European indices. In contrast, the US sample of 365 indices showed average exclusions of 19%, 23%, and 67% depending on the screen. The exclusion of sometimes large portions of the portfolio naturally impacts their risk profile, the extent of which is the focal point of the paper.

Balancing ESG considerations and Financial Risks

The first two exclusion screens had limited impacts on risk, especially when using an optimized reallocation method. The consensus screen caused a tracking error of 0.9% and 1.5% in Europe- and US-based funds, respectively. As a reminder, tracking error is a measure of the volatility of the difference in returns between a portfolio and a benchmark or reference index over a given period. Applying the PAB screen increased these values by about 0.5%. However, more ambitious exclusion strategies, like the SDG screen, led to more substantial levels of active risk—on average 4.7% in both European and US-based funds. For institutional investors, such levels call for some caution due to higher risks and potential deviations from sector norms, especially in the energy and utilities sectors.

Beyond active risk, the authors also show that exclusions tend to increase exposure to the “profitability” factor while slightly decreasing exposure to “value” and “investment” factors.

The study’s results have important implications for asset managers, and not only from a risk perspective. For instance, it was found that the reallocation methodology has an impact on the portfolio’s carbon intensity. The application of the consensus or PAB screens followed by a naïve reallocation of capital tends to reduce the portfolio’s carbon footprint. However, the same reduction may not occur with optimized reallocation, for reasons related to the optimization process. So, when using an optimized approach to minimize active risk, simple safeguards must be put in place to avoid an increase of the portfolio’s carbon footprint.

From the perspective of a fund manager, the study quantifies the trade-offs between fiduciary duties (focused on financial returns) and the desire to avoid harmful investments. While mild exclusions have minimal impacts on risk and performance, adopting stricter ESG criteria can increase the deviation from market norms, leading to heightened scrutiny from asset owners.

The study also raises the question of how sustainable funds can maintain their ESG integrity while avoiding significant changes of their risk profile. As ESG criteria become more stringent, the research suggests that optimized reallocation methods offer a way to balance these competing goals.

Conclusions and Future Directions

This research demonstrates that ESG exclusions affect the financial risk profile of equity portfolios, but these effects are often manageable. For mild exclusions, such as those based on consensus criteria, the financial impact is low, and the risks are considered acceptable. In contrast, more stringent exclusions, such as those aligned with the SDGs, can lead to higher tracking errors and deviations from traditional sector allocations. These findings emphasize the need for asset managers to understand how ESG exclusions impact the risk profile of their portfolios, and what they can do to manage them. (2)

The study contributes to the growing body of literature exploring the impact of non-financial criteria on equity portfolios, and offers practical insights for fund managers navigating the complexities of sustainable investing. Forthcoming research will provide a more granular view on the interplay between ESG criteria and financial risk.

References
(1) “Dark green” equity funds could go “full green” with very limited impact on their risk profile (May 2024). EDHEC Vox - https://www.edhec.edu/en/research-and-faculty/edhec-vox/equity-investors-dark-green-funds-full-green-very-limited-impact-risks

(2) See Scientific Beta (an EDHEC Venture) website - https://www.scientificbeta.com/