Authors: Gunnar Friede, Guido Lombardi, Peter Warken, Jason Chen, Dirk Schlüter, Robert Bush, Francesco Curto, Eric Legunn
Much research has been made in the past few years about how to integrate ESG in various asset classes; however, ESG research on a total portfolio level—or strategic asset allocation (SAA) level—is still very limited. As a 2019 PRI publication put it, the integration of ESG aspects in SAA “is an area that has received relatively little coverage about what it should mean in practice” 1.
This study seeks to address the current blind spot of research to further facilitate ESG integration comprehensively at an overall multi-asset portfolio level. The specific objective is on (i) understanding the potential impact of integrating ESG factors on risk-adjusted returns, (ii) what is the best approach to pursue to minimize impact. Our analysis concludes that it is possible to have portfolios that reduce significantly ESG risks without meaningfully different risk-adjusted returns vs traditional index SAAs at relatively low levels of tracking error (“TE”). We estimate that the optimal ESG impact can be achieved for TEs between 75 and 100bps, although an investor’s preference between their risk budget and ESG utility function will determine their appropriate trade-off between these two measures. Other findings:
- ESG integration can be run for either individual asset classes or at a total portfolio level. The combined approach (optimizing the SAA and implementing via ESG indices) is the most efficient approach from the standpoint of total ESG utility versus tracking error.
- Basic integration optimized across regional indices, sector indices, and ESG Indexes provides different levels of ESG 1 Principles for Responsible Investment. (September 2019). “Embedding ESG Issues into strategic asset allocation frameworks: Discussion paper.” improvement that depends highly on index/fund selection. The impact can vary from a reduction of 10% to F-rated (highest risks) stocks and carbon intensity to as much as 80% and 50% respectively for the same tracking error of 25bps.
- Changes in regional weights (e.g. having much more Europe vs the US than in the standard market-cap-weighted portfolio) improves the portfolio ESG characteristics only slightly.
- Better (ESG) results can be achieved by constructing the SAA with traditional sector indexes instead of regional ones.
Much better results can be achieved overall by allocating to ESG indexes. In this latter case, the share of worst ESG-rated securities 2 can be reduced by ca. 80% and the carbon footprint by 50% vs the traditional SAA – for tracking errors as low as 0.25%.
In the spirit of simplicity and wide applicability, our work has been focused primarily on liquid global asset classes for which there exist a replicable set of underlying indices. As such, we established this framework by leveraging readily available passive ESG indices, which we find sufficient in achieving the various parameters such as climate risk alignment. While we recognize that alternative asset classes and instruments can play a significant role in enhancing the ESG characteristics of a strategic portfolio, this framework is focused on presenting an intuitive, implementable solution for liquid asset allocations.
This article was reprinted with permission. Read the full paper here.
1Principles for Responsible Investment. (September 2019). “Embedding ESG Issues into strategic asset allocation frameworks: Discussion Paper.
2Ratings are based on the DWS ESG Engine. See appendix for more details.
MARKETING MATERIAL: For Qualified Investors (Art. 10 Para.3 of the Swiss Federal Collective Investment Schemes Act (CISA)) / For Professional Clients (MiFID II Directive 2014/65/EU Annex II) only / For Australia: For wholesale Investors only. For institutional investors only. Further distribution of this material is strictly prohibited. In the U.S. and Canada for Institutional Client and Registered Representative Use Only. Not for public viewing or distribution. Any hypothetical results presented in this report may have inherent limitations. Among them are the sharp differences which may exist between hypothetical and actual results which may be achieved through investment in a particular product or strategy. Hypothetical results are generally prepared with the benefit of hindsight and typically do not account for financial risk and other factors which may adversely affect actual results of a particular product or strategy. Any forward looking statements (forecasts) are based on but not limited to assumptions, estimates, projections, opinions, models and hypothetical performance analysis. All of which are subject to change at any time, based upon economic, market, and other considerations, and should not be construed as a recommendation.
For Investors in the United States: This document is intended for discussion purposes only and does not create any legally binding obligations on the part of DWS Group. Without limitation, this document does not constitute an offer, an invitation to offer or a recommendation to enter into any transaction. When making an investment decision, you should rely solely on the final documentation relating to the transaction and not the summary contained herein. DWS Group is not acting as your financial adviser or in any other fiduciary capacity with respect to this proposed transaction. The transaction(s) or products(s) mentioned herein may not be appropriate for all investors and before entering into any transaction you should take steps to ensure that you fully understand the transaction and have made an independent assessment of the appropriateness of the transaction in the light of your own objectives and circumstances, including the possible risks and benefits of entering into such transaction. You should also consider seeking advice from your own advisers in making this assessment. If you decide to enter into a transaction with DWS Group you do so in reliance on your own judgment.
The information contained in this document is based on material we believe to be reliable; however, we do not represent that it is accurate, current, complete, or error-free. Assumptions, estimates and opinions contained in this document constitute our judgment as of the date of the document and are subject to change without notice. Any projections are based on a number of assumptions as to market conditions and there can be no guarantee that any projected results will be achieved. Past performance is not a guarantee of future results. The distribution of this document and availability of these products and services in certain jurisdictions may be restricted by law. You may not distribute this document, in whole or in part, without our express written permission.
For Institutional Use and Registered Rep Use Only. Not for Public Viewing or Distribution. The brand DWS represents DWS Group GmbH & Co. KGaA and any of its subsidiaries, such as DWS Distributors, Inc., which offers investment products, or DWS Investment Management Americas, Inc. and RREEF America L.L.C., which offer advisory services. Investment products: No bank guarantee Not FDIC insured. May lose value DWS Distributors, Inc. 222 South Riverside Plaza, Chicago, IL 60606-5808 www.dws.com I rep@dws.com Tel (800) 621-1148 © 2021 DWS Group GmbH & Co. KGaA. All rights reserved. I-082544-1 (4/21)
