Our ESG team examines systematic evidence demonstrating that actively managing ESG tail risks may help to deliver sustainable investment performance over a market cycle.
ESG factors materialise mostly on portfolio downside – not upside
Avoiding large portfolio drawdowns triggered by ESG risks can help to contribute better risk/adjusted returns over market cycle
While focus on ESG tail risks is important, ESG risk avoidance per se is not a promising investment recipe
As the performance of ESG investment indices is often driven by unintended factor changes, passive, rules based ESG index strategies can be challenged
ESG and your portfolio: Managing tail risks through active integrated ESG investing
Astute corporations recognise the importance of environmental, social and governance (ESG) factors for future business success. Investors, too, are paying attention to ESG factors. Incorporating them into investment decisions seeks to provide higher risk-adjusted returns over a market cycle. In some places, such as the EU, there is pending legislation that requires that all funds are ESG risk-managed going forward. Investors are still trying to understand how to fully unlock the performance potenial of ESG risk integration into investment portfolios.
A recent AllianzGI study with a focus on ESG tail risks aimed to find out which process of ESG integration looks most promising.
To understand how ESG factors may affect portfolio risk and return, we analysed historic investment performance of European and global equity portfolios between 2008 and 2018. The study looked at three different areas related to ESG risk factors. First, we provided evidence for the materiality of ESG factors from a risk rather than a reward perspective. ESG is priced on the downside rather than the upside. Second, we analysed which lens investors should use to see how ESG portfolio risks affect their investment performance. Third, we examined the value of active investing and stewardship through corporate engagement and proxy voting.
We largely framed ESG risks in the following manner, which helped us to address and examine ESG portfolio risk in-depth.
Regulatory ESG Risk (i.e., ESG litigation, CO2 tax and trade)
Applies to nearly all asset classes
Our research indicated three clear results.
As a starting point, our research sought to answer whether portfolios that build on lower ESG risks have generated stronger returns compared to those that are exposed to higher ESG risks. Our findings, which are in line with other academic research on the subject, show that simply skewing portfolios to better ESG-risk-scoring holdings has not generated higher returns. However, our research provides good evidence that, historically, portfolios with a higher ESG risk profile have shown significantly more financial portfolio tail risk versus benchmark portfolios.
Accounting for ESG factors in your investment portfolio may be an effective way to generate alpha by helping to manage downside risks. Avoiding large portfolio drawdowns by ESG risk management has historically contributed to better risk-adjusted returns. The analysis, however, did not provide any significant correlation between highly rated ESG factors and outperformance vs benchmark.
Understanding the source of ESG risks and opportunities is key. We examined how different ESG risk scoring portfolios performed according to their extreme loss expectations: what is the difference in financial damage incurred in the worst 1% and 5% portfolio loss events? What is the difference in maximum portfolio drawdowns?
In doing this, we found that the relatively better ESG-risk-scoring investments have delivered a very similar risk profile compared to the benchmark. This is not the case when it comes to low ESG-risk-rated portfolios. The significant difference is in the lower tranche, indicating the importance of ESG as a source of tail risk. This may be addressed through fundamental research and active management.
It is important to note that, in our view, ESG risk is not about average portfolio risk, but instead about extreme events that are financially material and stem from an ESG-related source.
Our research provides further evidence that investors should not rely solely on investing in companies with high ESG ratings or simply avoiding high-ESG-risk holdings. There is evidence that a simple passive or tilted ESG strategy would actually overpay and would concentrate assets without exploiting an additional return potential. To address ESG risks attentively, there are a host of ESG factors that investors must consider, including constantly changing macro and regulatory dynamics, corporate fundamentals and market and political events that might play a part in future performance. We are convinced that active management that makes a judgmental risk/reward trade-off on ESG risks, i.e. properly incorporating ESG factors into portfolio composition, leads to better risk-weighted returns.
Investing involves risk. The value of an investment and the income from it will fluctuate and investors may not get back the principal invested. Environmental, Social and Governance (ESG) strategies consider factors beyond traditional financial information to select securities or eliminate exposure which could result in relative investment performance deviating from other strategies or broad market benchmarks. There is no guarantee that actively managed investments will outperform the broader market. Past performance is not indicative of future performance.
This is a marketing communication. It is for informational purposes only. This document does not constitute investment advice or a recommendation to buy, sell or hold any security and shall not be deemed an offer to sell or a solicitation of an offer to buy any security.
The views and opinions expressed herein, which are subject to change without notice, are those of the issuer or its affiliated companies at the time of publication. Certain data used are derived from various sources believed to be reliable, but the accuracy or completeness of the data is not guaranteed and no liability is assumed for any direct or consequential losses arising from their use. The duplication, publication, extraction or transmission of the contents, irrespective of the form, is not permitted.
This material has not been reviewed by any regulatory authorities. In mainland China, it is used only as supporting material to the offshore investment products offered by commercial banks under the Qualified Domestic Institutional Investors scheme pursuant to applicable rules and regulations. This communication's sole purpose is to inform and does not under any circumstance constitute promotion or publicity of Allianz Global Investors products and/or services in Colombia or to Colombian residents pursuant to part 4 of Decree 2555 of 2010. This communication does not in any way aim to directly or indirectly initiate the purchase of a product or the provision of a service offered by Allianz Global Investors. Via reception of his document, each resident in Colombia acknowledges and accepts to have contacted Allianz Global Investors via their own initiative and that the communication under no circumstances does not arise from any promotional or marketing activities carried out by Allianz Global Investors. Colombian residents accept that accessing any type of social network page of Allianz Global Investors is done under their own responsibility and initiative and are aware that they may access specific information on the products and services of Allianz Global Investors. This communication is strictly private and confidential and may not be reproduced. This communication does not constitute a public offer of securities in Colombia pursuant to the public offer regulation set forth in Decree 2555 of 2010. This communication and the information provided herein should not be considered a solicitation or an offer by Allianz Global Investors or its affiliates to provide any financial products in Panama, Peru, and Uruguay.
This document is being distributed by the following Allianz Global Investors companies: Allianz Global Investors U.S. LLC, an investment adviser registered with the U.S. Securities and Exchange Commission; Allianz Global Investors Distributors LLC, distributor registered with FINRA, is affiliated with Allianz Global Investors U.S. LLC; Allianz Global Investors GmbH, an investment company in Germany, authorized by the German Bundesanstalt für Finanzdienstleistungsaufsicht (BaFin); Allianz Global Investors (Schweiz) AG, licensed by FINMA (www.finma.ch) for distribution and by OAKBV (Oberaufsichtskommission berufliche Vorsorge) for asset management related to occupational pensions in Switzerland; Allianz Global Investors Asia Pacific Ltd., licensed by the Hong Kong Securities and Futures Commission; Allianz Global Investors Singapore Ltd., regulated by the Monetary Authority of Singapore [Company Registration No. 199907169Z]; Allianz Global Investors Japan Co., Ltd., registered in Japan as a Financial Instruments Business Operator [Registered No. The Director of Kanto Local Finance Bureau (Financial Instruments Business Operator), No. 424, Member of Japan Investment Advisers Association and Investment Trust Association, Japan];and Allianz Global Investors Taiwan Ltd., licensed by Financial Supervisory Commission in Taiwan.
About the author
Global Head of ESG
Dr Steffen Hörter is the Global Head of ESG at Allianz Global Investors which he joined in 2001. He is internationally responsible for the ESG integration strategy at AllianzGI including ESG Policy and Framework, ESG Investment Positioning, ESG Investment Offering/ Product Design and ESG Client Investment Advisory.
A low-growth, low-interest rate environment is firmly established globally, and a combination of external forces look set to inhibit any improvement for years to come. This makes investors’ hunt for income more complicated than ever.
Global growth is low and any improvement this year will be precarious; growth is set to slow further in the next few years.
Deflationary forces that emerged during the financial crisis evidently remain at work, and inflation expectations remain doggedly low.
Central banks are having to revise their strategy: it is no longer the time to raise interest rates.
Rates are set to remain lower for longer, with demographic and economic factors – including an ageing population and reduced productivity – adding to downward pressure on rates