ESG input reduces risk on emerging markets/corporate bond exposure: quant report

The rapid asset rebalancing by institutional investors into emerging markets investments and corporate bonds could drive up long-term investment risk for those that don’t integrate environmental, social and governance (ESG) factors into their portfolio construction, according to an adjusted study by quant researchers at risklab, part of Allianz Global Investors, the €1.5 trillion asset manager. Risklab said it had refocused an earlier study looking at ESG research integration implications on overall portfolio allocations to look at what the effects could be of increasing asset levels being moved into emerging markets and corporate debt. The original study, published last year, found that an ESG risk-optimized strategic asset allocation, when compared to an example balanced portfolio, could reduce tail risk by up to approximately one third, or add an additional expected return potential of up to 50 basis points (bps) per annum at the same level of risk. Portfolio tail risk is the likelihood a portfolio of assets will move more than three standard deviations from its current price. The latest Risklab study, titled: Responsible Investing Reloaded, shows that that the tail risk of an ESG risk adjusted emerging market equity strategy can be almost halved, dropping to -38.8% per annum compared with -64.5% per annum for an ESG neutral portfolio defined by the MSCI Emerging Markets Index.For corporate bonds, it said, the tail risk – measured as Conditional Value at Risk (95%) of the default strategy – can be reduced from -8.1% p.a. to -4.9% between an ESG adjusted portfolio and an ESG neutral portfolio as defined by the Merrill Lynch Global Broad Market Corporate Index. The risklab studies involve building a quantitative model of ESG risk factors in a portfolio to determine their influence on equity risk over a 20-year horizon. The firm chose carbon emission rights price changes and sector specific carbon footprint data for its E (environmental) data inputs, social performance risk data from GES Investment Services for its ‘S’ inputs, and governance ratings from RiskMetrics (now MSCI) for the ‘G’ risks in order to ‘operationalise’ ESG risks and run stochastic models with 10,000 different capital markets scenarios. Dr. Steffen Hörter, director at risklab, said: “In today’s capital markets investors are increasingly diversifying away from low yielding government bonds into growth assets, such as emerging market equities and corporate bonds, to achieve their investment aims. Our research shows that ESG risk factors can impact the extreme risk of these asset classes significantly.”
Link to Risklab report
Responsible-Investor.com and C5 will hold their Sustainable Emerging Markets Conferences in London on May 24/25: Link for further details