Investing in ways that contribute to net zero greenhouse gas emissions by 2050 and beyond is increasingly a concern for most investors, in particular institutional investors. For this reason, we have studied various approaches to aligning our multifactor equity strategies with net zero objectives.
In our most recent paper, “Equity Factor Investing with Paris Aligned constraints”, we give insights into applying Paris Aligned Benchmark (PAB)-type constraints to multifactor equity investing and we investigate the impact of imposing the minimum requirements and voluntary criteria in the European Union regulation on PABs on the expected returns and risk of multifactor equity strategies.
Multiple possibilities to align the multifactor strategy
We explored various approaches to render the multifactor portfolio ‘Paris-aligned’.
First, just changing the benchmark from a traditional market capitalisation-weighted index to a PAB is not sufficient to align the multifactor strategy. In fact, we could have just changed the benchmark and kept the original multifactor portfolio. That would likely result in a higher tracking error versus the benchmark as well as failure to align the strategy with net zero objectives.
Indeed, alignment constraints must be applied directly to the portfolio itself (changing the benchmark is just optional). Accordingly, we applied the alignment constraints in the EU regulation on PABs to the portfolio, making no further changes and keeping the original market cap-weighted benchmark and investment universe in place.
This approach suits investors who continue to benchmark performance against traditional market cap-weighted indices in terms of expected returns and risk. We used portfolio optimisation to minimise the impact of the alignment constraints on the original exposure of the portfolio to the value, quality, low risk and momentum factors, i.e., on the drivers of performance in this strategy.
While imposing alignment constraints on the portfolio is a necessary condition, we could also consider replacing the market cap-weighted benchmark with a PAB and/or limiting the investment universe to the constituents of the PAB.
In our paper, we investigated all these possibilities, always using portfolio optimisation to minimise the impact of constraints on the original factor exposures driving the performance of the multifactor portfolio.
Avoiding historical simulations
The traditional approach used by quantitative managers to address questions about expected returns and risk is to construct historical simulations of what the strategies would have generated in the past. However, relevant company carbon emissions data lacks historical depth, making it difficult to construct historical simulations without introducing strong approximations.
Moreover, such simulations would not consider changes in regulations, technological advances and shifts in market sentiment related to the need to decarbonise the economy. Finally, the dynamic nature of the actual PAB constraints with regards to decarbonisation pathways makes it almost irrelevant to use historical simulation methods.
Instead, we opted for a simpler approach that sheds light on the expected impact of PAB-type constraints now and in the short to medium term. This is based on investigating how the PAB-type constraints change the targeted factor exposures that drive the expected performance and risk of the portfolio. In our paper, we describe the methodology to run this analysis on a given date.
The recommendations
Overall, we found that imposing PAB-type constraints directly on a multifactor portfolio while keeping the market cap-weighted index as the benchmark and as the investment universe is the most effective approach to aligning the portfolio while minimising the impact on expected returns and risk.
In fact, the minimum requirements of the EU PAB regulation have hardly any impact. We also found that only specific voluntary criteria could affect expected returns.
Even changing the benchmark to a PAB to manage the tracking error is not expected to affect the expected returns of the portfolio significantly if we apply only the minimum PAB requirements, and the portfolio is not constrained to invest only in stocks in the PAB index.
Beyond PAB-type constraints
In our paper, “Aligning Investments with the Paris Agreement: Frameworks for A Net Zero Pathway”, we compared four different frameworks for net zero investing:
- A forward-looking approach Net Zero Achieving, Aligned, Aligning (AAA) screens
- The Paris Aligned Benchmark (PAB) rules
- Fossil fuel exclusions
- Clean energy thematic investing.
The approach followed here for PAB-aligned multifactor equity investing could also be applied to gain insights into how the other frameworks would impact the expected returns and risk of multifactor portfolios.
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