A new paper from BNP Paribas Asset Management, “Impact of ESG Objectives on a Portfolio”, recently published in The Journal of Portfolio Management, details a framework for adding environmental, social, and governance objectives to passively and actively managed equity portfolios so that the impact of the ESG criteria on risk and return is minimised.
For many investors and asset managers, extra-financial objectives based on ESG factors have gained significant prominence among the characteristics of the funds they invest in. As a measure of that importance, there is a growing array of regulations that govern the ’non-financial’ objectives of funds.
French regulator Autorité des Marchés Financiers (AMF) sees the Sustainable Responsible Investing (SRI) label for non-financial objectives as imposing a constraint on the average ESG score of a portfolio. The EU’s Sustainable Finance Disclosures Regulation (SFDR) requires fund prospectuses to disclose a percentage-based objective for alignment with the EU Taxonomy and ‘Sustainable Investments’ [1]. These objectives have been incorporated into the EU’s Markets in Financial Instrument Directive (MiFID) to address the ESG preferences of retail investors.
Implications for passive and active management
Managers of passive funds may have no specific views on the expected impact of ESG objectives on portfolio performance.
When they aim to construct a new index that qualifies for a sustainable fund label starting from a traditional market capitalisation benchmark, their goal should be to minimise the impact of the constraints of such a ‘green label’ on the ability to replicate the performance of the given index.
However, even active portfolio managers incorporating ESG factors into their investment process face challenges.
They must ensure their final portfolios meet specific constraints and objectives based on a host of extra-financial factors if they are to qualify for the above-mentioned fund labels. This can quickly become an insurmountable task without the appropriate portfolio construction tools.
An effective method for implementing ESG constraints
The paper’s authors [2] propose a framework that minimises the impact of constraints. They investigate the effects of integrating voluntary objectives based on specific extra-financial criteria.
Examples include objectives based on ESG scores, EU Taxonomy alignment, the SFDR definition of ‘Sustainable Investments’, and classifications linked to the AAA net zero framework inspired by the Paris Aligned Investment Initiative (Achieving, Aligned, or Aligning companies).
Key findings
- For managers of passive funds such as exchange-traded funds (ETFs) or index funds, the proposed framework for minimising the impact of constraints when mimicking an index shows a straightforward relationship between the tracking error of the new portfolio relative to the original index and the level of imposed ESG objectives. The simplicity of this solution helps define reasonable ESG aims and compare the impacts of various ESG-based objectives.
- For active portfolio managers, the framework assumes such a manager has views on stocks and has already constructed a portfolio against a given benchmark. However, even if ESG factors were considered in the investment process, the resulting portfolio might still not meet all specific ESG constraints and objectives. The goal is to construct a new portfolio that satisfies all constraints and objectives while maintaining a comparable expected return. Applying the framework results in simple relationships between the expected portfolio return and the ESG objectives.
- For actively managed portfolios, the more the original active portfolio is based on an investment process with embedded ESG views aligned with the targeted ESG objectives, the smaller the expected impact on portfolio returns when aligning the portfolio with those objectives.
Minimising the impact of constraints
The paper investigates the effects of using the proposed methodology to minimise the impact of constraints and offers examples for passive and active managers.
Passive portfolio: Minimising the tracking error of the constrained portfolio against a given index and defining reasonable ESG objectives according to their relationship with the tracking error. The paper includes examples of closed formulas relating the tracking error to multiple extra-financial objectives.
Exhibit 1 summarises examples of reasonable objectives based on three criteria as a function of the increasing portfolio tracking error relative to the MSCI Europe index as the benchmark. With a 1.5% tracking error, the portfolio could be fully invested in sustainable investment grade stocks only, with a significant increase in exposure to EU Taxonomy revenues to 20.7%, and with an increase of 13.5 points, or 22.6%, in the ESG score relative to the benchmark.
Active portfolio: To establish objectives that limit deviations in both expected return and tracking error, the paper includes examples of closed formulas relating the expected returns of the new active portfolios to the objectives it is forced to meet.
The charts in Exhibit 2 illustrate the impact on excess returns when modifying an active portfolio while maintaining the same tracking error. The left-hand chart shows the effects of meeting different ESG target levels, while the right-hand chart focuses on achieving a specific allocation to stocks that qualify as ‘Sustainable Investments’.
The framework also helps portfolio managers to understand how quickly a given constraint can reduce expected returns as it diverts the portfolio from the initial optimal allocation that fully reflects the active manager’s views.
Valuable insights
In summary, we believe the proposed framework provides valuable insights into setting reasonable ESG objectives and managing the trade-offs between ESG goals and financial performance for both passively and actively managed portfolios. The relationship between tracking error and ESG objectives is defined by closed formulas, making it highly transparent and easy to use.
Further reading: What impact do sustainability criteria have on portfolio performance
[1] The SFDR defines sustainable investment as: a) an investment in an economic activity that contributes to an environmental or social objective; b) the investment does not significantly harm any environmental or social objective; and c) investee companies follow good governance practices in particular with respect to sound management structures, employee relations, remuneration of staff and tax compliance https://www.esma.europa.eu/sites/default/files/2023/ESMA30-379-2279_Note_Sustainable_investments_SFDR.pdf
[2] François Soupe and Guillaume Kovarcik
