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.

Our research indicated three clear results.

ESG factors are not pricing the average portfolio returns upwards, but only define the exposure to downside risks.

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.

Managing low ESG-rated holdings is more relevant for compound returns than tilting towards high ESG-rated companies in portfolios.

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.

Active management is key to properly incorporating ESG factors into portfolios.

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.

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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.

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