Thoughtful in-sector substitutions can mitigate many of the risks of aligning a portfolio with net-zero targets, Guido Baltussen tells [i3] Insights.
As more institutional investors commit to reaching net-zero emissions in their investment portfolios by 2050, Northern Trust Asset Management has noticed there are some enduring misconceptions about the impact of this pledge on investment strategies.
There are two misconceptions in particular that seem prevalent. The first is that a net-zero approach means investors have to take high active risk and, therefore, incur a high level of tracking error.
In the context of Australia’s Your Future, Your Super legislation and its associated performance test, high tracking error can put funds in a precarious position.
The second misconception is that the integration of climate-related considerations will limit the ability of factor-based strategies to deliver alpha.
In a recent paper, “Carbon Misconceptions: Clarifying the Impact of a Net-zero Commitment on Equity Portfolios”, Northern Trust Asset Management shows that these misconceptions are demonstrably false.
“Between the two misconceptions put forth, we find the notion that a net-zero commitment requires significant active risk to be the most deeply entrenched. This is understandable as many ‘sustainable’ products indeed exhibit high levels of tracking error,” the authors of the report say.
“[But] in general, significant reductions can be achieved for very little active risk, as for example 50 basis points can be sufficient to achieve an 80 per cent reduction.”
The authors do acknowledge that once investors are aiming for reductions greater than 80 per cent, active risk increases markedly. For example, they found that if investors target a 90 per cent reduction, active risk almost doubles to 93 basis points.
[i3] Insights spoke with Guido Baltussen, Head of Quantitative Strategies – International at Northern Trust Asset Management, about the report.
Baltussen argues that tracking error can be kept relatively low by substituting those companies that you underweight or screen out with companies that have a similar profile as the exclusions within, for example, the same sector.
As an investor, be intentional about the risks that you take. Because if you do it more naively and throw out the high carbon emitters and distribute portfolio weights proportional across the remaining universe, then you don't cover the risks to your portfolio
“As an investor, be intentional about the risks that you take. Because if you do it more naively and throw out the high carbon emitters and distribute portfolio weights proportional across the remaining universe, then you don’t cover the risks to your portfolio,” he says.
“For example, let’s say these are some big energy names and then you tilt away from the energy to the IT sector. Your risk profile of your portfolio becomes quite different. You need to be mindful of that.”
But often substitutes for exclusions are available within their own sectors, even within the energy sector, he says.
“The energy sector is a very wide sector. If you look in there, there are also a lot of transition-related firms and enablers in there. Energy companies, of course, have the highest carbon footprint, but at the same time some of them are also the biggest investors in transition to a green economy,” he says.
Being thoughtful about how to substitute exclusions or underweights can go a long way in helping investors address the problem of unintended risks. It is only when investors are nearing net zero that substitution becomes more problematic, Baltussen says.
“If you target very extreme carbon reductions, then it affects such a big chunk of your investment universe that there are too few names remaining and actively controlling risks tightly becomes more problematic,” he says.
Factor Skews
A number of asset owners who started reducing the exposure of their equity portfolios to high carbon-emitting businesses a number of years ago found their portfolios had taken on a skew towards the growth factor, overweighting those companies that are more driven by expectations of high growth, such as certain technology companies.
Not only that, but when Russia invaded Ukraine it also became clear these greener portfolios were exposed to a number of key macroeconomic risks, in particular rising energy prices and interest rates.
These two risks combined caused many portfolios to underperform.
Baltussen argues that risks introduced by carbon reductions can also be dealt with by managing a portfolio’s sector exposure.
“This is something that we encounter quite often. For example, when tilting away from the energy sector, any shock to energy prices might have quite some impact. You introduce a lot of macroeconomic risk in your portfolio,” he says.
“At the same time, portfolios tend to be tilted towards more expensive names driven by growth expectations, for example, on the back of the energy transition – a tilt that is often unintentional.
“[But] a lot of the macroeconomic and growth skew effects can be [mitigated] within a sector, so selecting the best-in-class, well-valued companies within a sector. That allows you to onboard less of that macroeconomic or growth risk in your portfolio.”
The same method can be applied when investors are looking for intentional skews, such as having a value tilt in the equity portfolio, or when they need to increase their exposure to a factor to maintain a factor-neutral portfolio.
Value tends to be a bit more exposed to brown companies, especially if you look at it from a sectoral perspective. [But] if you play value more within sectors, then you can achieve carbon reductions while maintaining the level of value exposure
“Value tends to be a bit more exposed to brown companies, especially if you look at it from a sectoral perspective,” Baltussen says.
“[But] if you play value more within sectors, then you can achieve carbon reductions while maintaining the level of value exposure. So in that sense, it’s not necessary that you need to tilt too much to the growth companies.”
Low-volatility strategies tend to be impacted most by carbon reduction strategies as the utilities sector is a key sector in defensive strategies and utility companies are the least equipped for the carbon transition.
“You can also harvest a low-volatility factor within sectors. It remains quite effective in reducing the risk of your portfolio. If you are mindful of the sector risks that you have and constrain them more, then the risk profiles on your low-volatility factor becomes much lower. The risk/return trade-off becomes more favourable,” Baltussen says.
This is also the reason why investors can target active factor strategies while committing to net zero.
“If you explicitly target these value exposures, or control that in your portfolio settings, and your investment universe is wide enough, like in the case of the MSCI World or MSCI ACWI [indexes], then you have so many names with similar kind of carbon intensities or carbon footprints that you can still maintain your factor content by smartly reallocating across these number of names,” Baltussen says.
Scope Three
Measuring emissions under scope 1 and 2 has become increasingly more accurate as companies release better data on their carbon footprint and the industry is moving towards greater standardisation of metrics.
But scope 3 emissions are still hard to quantify and contemporary approaches often take the form of estimations, while data varies more widely among different data providers than with scope 1 and 2.
Yet scope 3 emissions are likely to have the biggest impact as it involves a company’s entire value chain.
The carbon intensity or carbon footprint in the investment universe is quite skewed; it is unevenly distributed. There are some very large emitters and avoiding those already helps you to achieve the bulk of carbon emissions
Northern Trust found there is a clear relationship between a company’s scope 3 emission intensity ranking and its sales-to-price ratio, a typical value metric. This relationship can be interpreted as evidence that the market is pricing carbon emissions risk, but it also reflects the fact companies in growth sectors, such as information technology, have lower carbon footprints than those in mature industries.
Luckily, the bulk of these emissions are produced by a relatively small number of companies, which enables investors to easily substitute these businesses with sector peers.
“The carbon intensity or carbon footprint in the investment universe is quite skewed; it is unevenly distributed. There are some very large emitters and avoiding those already helps you to achieve the bulk of carbon emissions,” Baltussen says.
“And then if you want to reduce risk further, then be mindful of the sectors from which they came. What was the risk profile of these firms? Replace it with matching firms. That helps you to really control that risk and be mindful of the risk that you take in your portfolio.”
This article is sponsored by Northern Trust Asset Management. As such, the sponsor may suggest topics for consideration, but the Investment Innovation Institute [i3] will have final control over the content.
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[i3] Insights is the official educational bulletin of the Investment Innovation Institute [i3]. It covers major trends and innovations in institutional investing, providing independent and thought-provoking content about pension funds, insurance companies and sovereign wealth funds across the globe.