Quant study shows significant, long-term ESG risk reduction and return boost

The integration of ESG factors into portfolio construction could significantly reduce long-term investment risk and potentially boost returns because of a high probability that companies that don’t manage ESG issues will be more volatile, according to a study by quant researchers at risklab, part of Allianz Global Investors. The quant firm said the research was important because it had notable implications for investor strategic asset allocation decisions, which it said accounted for up to 90% of long-term portfolio risks and are a significant driver of returns. The study, titled: ‘ESG Risk factors in a Portfolio Context’, involved 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 spot price changes of carbon emission rights as a proxy for environmental risks, employee sick days as its social risk criteria, and corporate governance ratings, to ‘operationalise’ ESG risks and run stochastic models with 10,000 different capital markets scenarios. As a reference, risklab created a conservatively balanced portfolio with 30% global equities and 70% bonds and measured the impact of each ESG factor on equity risk within two distinct groups: positive ESG equity where company management actively tries to minimise the ESG risk, and negative ESG where the risks are ignored. It then replaced the 30% global equity ofthe reference portfolio with either positive or negative ESG equity strategies. It found that the optimised positive ESG equity allocation gave a portfolio tail risk reduction – the likelihood that the risk of a portfolio of assets will move more than 3 standard deviation from its current price – of around 30%, at the same levels of expected return. The same portfolio also gave an increase of expected return of 30 basis points at similar levels of expected portfolio risk. The effects, risklab said, were amplified when comparing riskier portfolios with higher equity allocations. Dr. Steffen Hörter, director at risklab, said: “While much research has been done on ESG opportunities at the stock picking or company analysis level, little has been researched on the link between ESG and the risk/return profile of an entire portfolio. The connection to the portfolio context and strategic asset allocation, which we view as the most important factor driving long-term portfolio returns, has been missing. In the long-term, ESG factors are expected to have significant tail risk impact on equity investments. Therefore, investors should strive to optimise their global equity investments and minimise exposure to ESG risks, which could be achieved by choosing equity investments, where corporate management proactively mitigates these risk factors.”
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