Getting the tobacco hit without tobacco?

While tilting and positive screening may not be suitable for an investor looking to avoid tobacco exposure, portfolio tilts are an increasingly popular way of adjusting exposure to issues like fossil fuel reserves and green revenues.

Investors have a range of options when it comes to reflecting their sustainable investment beliefs in index-based portfolios. Traditional approaches have focused on exclusions as a way of completely removing exposure to a given issue—such as tobacco.

However, implementation approaches have evolved to allow investors to adjust their portfolios in different ways depending on how sensitive they are to the issue at hand. These include tilting or positively screening portfolios, both of which involve reducing exposure to the things you don’t want in your portfolio and increasing exposure to the things that you do. While tilting and positive screening may not be suitable for an investor looking to avoid tobacco exposure, portfolio tilts are an increasingly popular way of adjusting exposure to issues like fossil fuel reserves and green revenues.

As the ESG investing landscape has grown and evolved, the popularity of exclusionary approaches has remained a constant. The most recent data from Eurosif shows that exclusionary strategies have attracted three times the assets under management compared to the next most popular strategy (voting and engagement).1

At FTSE Russell, we’ve launched several index series over the years to meet this demand. Back in 2001, we launched the FTSE4Good Index Series, which incorporates exclusions alongside strict minimum ESG standards. And 2014 marked the launch of our FTSE ex Fossil Fuels Index Series, which gives investors a tool for excluding companies with certain exposure to fossil fuels. More recently, we introduced the FTSE Global Choice Index Series, which applies exclusionary screens based not only on a company’s products but also on its conduct.

A consideration for investors that go down the exclusions route is that the portfolio can include unwanted factor biases. To address this potential outcome, we explored how an exclusionary approach to tobacco could be paired with a multi-factor index constructed to correct for factor biases.

Deliberately or otherwise, portfolio construction based on alternative characteristics typically introduces biases such as factor exposures—and this includes ESG implementation based on the use of exclusions. However, with the emergence of multi-factor indexes it might be possible to adjust for these implications.

For example, when tobacco companies are excluded from the FTSE Developed Index, the resulting FTSE Developed ex Tobacco Index has a negative tilt toward quality, volatility, and yield factors, and a positive tilt toward size. We experimented with adjusting for these active factor exposures by creating a hypothetical index that simulates tobacco stock characteristics.

When this hypothetical index is combined with the FTSE Developed ex Tobacco Index in proportion to their market cap weights, we create a composite index that provides the same factor exposures as the parent index (FTSE Developed) but without tobacco exposure.While the hypothetical FTSE Developed ex Tobacco Factor Composite Index doesn’t entirely replicate the performance of the FTSE Developed Index, it’s a closer approximation than the FTSE Developed ex Tobacco Index. The chart below shows total return performance over the past 15 years for both of these indexes relative to the FTSE Developed Index, illustrating tighter tracking for the factor composite index.

This experiment demonstrates that while an exclusionary approach to ESG investing may come with portfolio implications, multi-factor indexes could provide a tool for neutralizing unintended or unwanted factor exposures. In this particular case, we were able to create synthetic tobacco exposure by using factors to simulate tobacco stock characteristics. This approach could be extended to other ESG implementation approaches, illustrating how multi-factor index construction is increasingly helping investors integrate ESG into index design while maintaining broad market or factor-related index characteristics.

One final point on tobacco equities. Excluding them from broad diversified portfolios over long periods has historically resulted in lower returns over most time periods, but of course, past performance is no future guide. Moreover, some investors, such as the French pension fund FRR, have suggested that the industry may suffer below market returns in the future if emerging markets tighten up anti-tobacco regulation and taxes as developed markets have already done.

Aled Jones is Head of Sustainable Investment at FTSE Russell.

This article was sponsored by FTSE Russell and RI editorial staff were not involved in the creation of this content

Source: FTSE Russell as at 12/29/2017. Past performance is no guarantee of future results. Returns shown for the FTSE Developed ex Tobacco and FTSE Developed ex Tobacco Factor Composite Indexes are hypothetical historical data. Please see the end for important legal disclosures.

[1] Eurosif SRI Study 2016, see here

Disclaimer on Page 2.

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