Since 1970, April 22nd has been a day of supporting environmental protection. As we embrace this day focused on sustainability, it is appropriate to highlight how investors can align their environmental values and investment objectives.
Interest in ESG portfolios is growing. Last year, U.S. sustainable fund flows totaled $51.2B, more than double the 2019 figure and ten times larger than 2018. Additionally, a recent global survey on ESG initiatives stated that 88% of respondents ranked Environment as their top priority.1
Today, companies and industries vary in how they recognize, address, and report on environmental-based risks. Given these differences, there are many avenues for expressing "environmental protection" in an investment portfolio. This piece details just one of these approaches.
ESG portfolios are typically built using three core levers, which are highlighted below:
3) Active Ownership
The environmental protection model incorporates all three: it overweights companies with strong emphasis on issues like climate change, pushes poor scoring companies to change through proxy voting, and completely divests when the misalignment in values is too large.
Exclusions: The model excludes companies with business ties to operations that negatively impact the environment: Oil & Gas, Oil Sands, Nuclear, Arctic Oil & Gas Exploration, Shale Energy, Thermal Coal, and companies with high carbon intensity. It also divests from companies involved in any severe environmental related controversies.
Tilts: After these exclusions, we “score” our investible universe on environmental protection metrics and overweight stronger-scoring companies, while underweighting and/or removing lower-scoring ones. We use proprietary data, our ESG scoring convention, and our risk-optimization engine to score and construct ESG portfolios. Our scoring framework incorporates the themes below:
1) Carbon Footprint & Climate Change
2) Carbon Intensity
3) Pollution & Waste Management
4) Water Stress
5) Resource Use
6) Deforestation & Biodiversity
7) Environmental Impact of Products & Services
After completely removing the lowest scoring “environmental protection” companies, we increased the environmental protection score of the top scoring quintile of companies by 28% and decreased the bottom scoring quintile of companies by 30% – all while maintaining the efficacy of the underlying investment model.2 Advisors have the flexibility to increase/decrease the “tilt level” to control for tracking error.
Active Ownership: Owning public equities provides the opportunity to vote on shareholder issues. Adding environmentally responsible proxy voting enables an active ownership approach for further influencing portfolio companies. Specific to the environmental protection model, we proxy vote in a way that promotes mitigation of climate risks, plans for more renewable energy use, and yields additional transparency on environmental initiatives like current emissions and/or renewable energy targets.
In addition to maximizing exposure to companies most aligned with environmental protection values, advisors often want return characteristics to closely match their firms high-conviction investment model. In other words, we find their most common goal to be significantly improving the pro-environmental protection exposure in the new model while maintaining the efficacy of their legacy investment model. We strive to be the platform where advisors can offer custom, values-based portfolios with unrivaled specificity – in this case, controlling for tracking error to marry risk-adjusted return and environmental-based goals.
There is no single way to address environmental values in a portfolio. Most of our clients use a combination of exclusions, tilts, and proxy voting, but every portfolio is truly unique. This fits our belief that values-based investing is never one-size-fits-all and is better accomplished through a customizable, separately managed account. For advisors interested in portfolios with an environmental focus, within our Canvas platform, you can access the above model, build a variation of it, or create something entirely new. Our mission is to precisely match unique values and investment objectives. Happy Earth Day and make it a point to get outside today!
If you are an advisor and have an ESG model or mandate in mind, we would love to talk: email@example.com.
2 As of December 2020
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The risk-free rate used in the calculation of Sortino, Sharpe, and Treynor ratios is 5%, consistently applied across time
The universe of All Stocks consists of all securities in the Chicago Research in Security Prices (CRSP) dataset or S&P Compustat Database (or other, as noted) with inflation-adjusted market capitalization greater than $200 million as of most recent year-end. The universe of Large Stocks consists of all securities in the Chicago Research in Security Prices (CRSP) dataset or S&P Compustat Database (or other, as noted) with inflation-adjusted market capitalization greater than the universe average as of most recent year-end. The stocks are equally weighted and generally rebalanced annually
Hypothetical performance results shown on the preceding pages are backtested and do not represent the performance of any account managed by OSAM, but were achieved by means of the retroactive application of each of the previously referenced models, certain aspects of which may have been designed with the benefit of hindsight
The hypothetical backtested performance does not represent the results of actual trading using client assets nor decision-making during the period and does not and is not intended to indicate the past performance or future performance of any account or investment strategy managed by OSAM. If actual accounts had been managed throughout the period, ongoing research might have resulted in changes to the strategy which might have altered returns. The performance of any account or investment strategy managed by OSAM will differ from the hypothetical backtested performance results for each factor shown herein for a number of reasons, including without limitation the following:
Please Note: Socially Responsible Investing Limitations. Socially Responsible Investing involves the incorporation of Environmental, Social and Governance considerations into the investment due diligence process (“ESG). There are potential limitations associated with allocating a portion of an investment portfolio in ESG securities (i.e., securities that have a mandate to avoid, when possible, investments in such products as alcohol, tobacco, firearms, oil drilling, gambling, etc.). The number of these securities may be limited when compared to those that do not maintain such a mandate. ESG securities could underperform broad market indices. Investors must accept these limitations, including potential for underperformance. Correspondingly, the number of ESG mutual funds and exchange traded funds are few when compared to those that do not maintain such a mandate. As with any type of investment (including any investment and/or investment strategies recommended and/or undertaken by OSAM), there can be no assurance that investment in ESG securities or funds will be profitable, or prove successful.
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