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Asset allocators are increasingly facing a novel challenge when constructing portfolios: striking a balance between ESG factors and traditional performance objectives to achieve positives outcomes on both fronts.

Investors are accustomed to considering risk and return as the two dimensions that guide asset allocation. We find that two additional elements, time and preference, are needed to augment this process in an ESG world. We believe these fresh considerations are poised to have a transformative impact on the traditional pillars of asset allocation.

The time element refers to the duration of the ESG transition underway as governments and companies introduce regulations, new technologies and investments to reduce pollution in line with the principles of the Paris Agreement, adopted by 196 parties at COP 21 in 2015, and fulfill the Sustainable Development Goals relating to social responsibility and governance¹. During this transition period, we believe that ESG-oriented strategies are well-positioned to capture potential gains from new technologies compared to traditional benchmarks. Active investors that incorporate ESG analysis into their approach may disproportionately benefit.

¹ The UN Sustainable Development Goals (SDGs) consist of 17 sustainable development goals that are part of its 2030 Agenda for Sustainable Development.

The preference element refers to the weight an investor places on prioritizing sustainability in an investment portfolio, either due to regulatory requirements or the objectives of the investor or organization and its board. For these investors, the issue is how to optimize portfolios to address risk and return in concert with ESG. The impact depends heavily on the magnitude of ESG constraints. Historical data show that there has been no trade-off between sustainability and investment performance for conventional ESG benchmarks. For example, comparing the MSCI World Index with the MSCI World ESG Focus index for the 2011-2020 period, the difference in compound annual total return was 0.2% (in favor of the ESG index) and the annual standard deviation difference was 0.1% (16.7% for the MSCI World Index vs. 16.8% for the MSCI World ESG Index).

While it is possible that in the future higher-level and more standardized disclosure will help investors select ESG leaders more robustly, we find that the current data already helps produce sustainable portfolios where risk and return are not significantly different, statistically speaking, from those of traditional portfolios. Therefore, we suggest that there is no need for separate risk and return expectations for sustainable investments over very long horizons (in equilibrium).

The adoption of modern ESG approaches, which are less restrictive in terms of exclusion and minimize tracking error from the original indexes, historically has not impaired performance, as shown by the performance of the MSCI World Index vs. the World ESG Index mentioned above and may have the positive externalities of contributing to stronger and more sustainable economic and social growth. Therefore, our asset allocation framework seeks to optimize a portfolio’s expected risk and expected return while also integrating ESG.

Benefits are visible with investors in general being more ESG motivated and more informed about what kind of companies they are investing in, and what future risks and returns could look like. Over the short term, we believe investors and institutional investment boards may have opportunities to capture excess returns as ESG assets may become more popular and potentially valued higher in the market.

Building a foundation for efficient portfolio construction

When optimizing an asset allocation, one can take ESG scores from a vendor to each asset class and then optimize in three dimensions: return, risk and ESG score. The weight in the optimization given to ESG proxies for the preference: if an investor is not interested in ESG, the weight will be zero and the optimization will be the traditional mean-variance; if the investor has great interest in ESG, the weight parameter in the objective function will be large and skew the allocation towards highly-rated assets.

The use of ESG scores to redefine the investment universe results in a four-dimensional surface with return, risk, time and ESG score on the axes, rather than the classic two-dimensional risk/return frontier. Relatively light constraints (gray line) under this approach leave this new frontier close to the unconstrained efficient frontier (brown line).

Very strict ESG constraints (red line) will reduce the investable universe, leading to less efficient portfolios and a lower efficient frontier. It is however possible that a conventional ESG investor, over the next few years, may enjoy early-adopter gains from owning assets that everyone wants, leading to a higher (dashed green) efficient frontier for a limited time.