Investors have a variety of objectives when they pick sustainability or climate-related funds. Certainly, there is an expectation of positive returns, in addition to the collateral benefit.
In the case where an index is built based on an exclusionary or environmental, social, and governance (ESG) integration strategy and further optimized to meet a climate goal such as the Paris Climate Accord, the geopolitical atmosphere is sure to provide demonstrable insights on the performance of funds built on such tactics.
Using E-Score and T-Risk methodologies, Entelligent has created strategies meant to optimize portfolios while meeting the goal of aligning to the Paris Accord temperature goals, as well as maximizing carbon exposure reduction or returns in high-climate adaptation scenarios. After running these strategies for the first quarter of 2022, the results have emerged: The portfolios created using these strategies generally underperformed the benchmarks. Nonetheless, investors should not be overly concerned. Let’s take a deeper look at what happened and the ways in which this serves to validate the methodologies used.
Entelligent’s scores are designed to evaluate equity performance as the world moves from business as usual to climate action. This includes the implementation of adaptation and mitigation policies that would put us on track toward a 3.2°C scenario in the case of E-Score (a more conservative scenario) or a scenario of below 2°C in the case of T-Risk (a more aggressive scenario).
Unfortunately, the last few months have revealed that the world is backsliding. Particularly during the conflict in Ukraine, nations are doubling down on fossil fuels, including the U.S., encouraging fossil fuel suppliers worldwide to increase production. Clearly energy and climate policies are neither orderly nor fully coordinated across nations. This means the planet’s climate status is in the upper right quadrant of the SSP (Shared Socio-economic Pathways) matrix where achieving a temperature increase below 2°C is mathematically infeasible.
The underperformance is largely due to the minimizing of exposure to fossil fuel companies (as well as defense contractors) to comply with ESG restrictions in portfolio construction. In times of war, energy and defense stocks are often leading performers. These sectors have enjoyed a big boost—energy was up more than 38% year to date as of May 10 based on the S&P energy benchmark—while the overall market was down about 15% as of the same date based on the S&P 500.
But times like this are prime opportunities to test the validity of investment concepts. A strategy designed to optimize returns under conditions that rely on temperature increases closer to 3.2°C or 2°C scenarios would not compare favorably with investments where a 4°C scenario is more likely. Professional investors understand that certain strategies perform better in certain environments.
For example, growth stocks outperform in bull markets but tend to take the biggest losses in bear markets. Conversely, value stocks underperformed growth stocks over the past five years but have surged recently in an inflationary environment with interest rates rising and are expected to rise further. An ESG—and, particularly, a climate risk methodology—that advances no matter the socio-economic and political environment should make investors apprehensive.
The fact that in the E-Score and T-Risk derived strategies exposure to the least environmentally friendly sectors is minimized means that in times of upheaval the upside of companies most profiting from war will not be captured.
The back-tested results of a T-Risk powered index juxtaposed with the SPDR S&P 500 ETF Trust (SPY) and the Partnered E-Score Paris Aligned Net Zero index juxtaposed with the iShares MSCI ACWI ETF (ACWI) are displayed below. Thus far in 2022, ESG portfolios and strategies that are underweight or exclude energy stocks are more likely to fall or underperform than those that do not.
The return performance of these strategies should not detract from the gains they make in terms of their carbon impact and exposures. As shown in the table below, the Partnered E-Score Paris Aligned Net Zero index strategy returned a whopping 87% reduction in carbon growth for the index constituents and an impressive 45% improvement in both carbon intensity and total emissions.
For investors taking positions intended to capture the benefits of ESG investment choices and insulate against the effects of a climate-buffeted world, keeping sight of the collateral benefits is important to weather bumps in the markets.
Dr. Elliot Cohen also contributed to this article.
This blog post has been written by a third-party contributor and does not necessarily reflect the opinion of FactSet. The information contained in this blog post is not legal, tax, or investment advice. FactSet does not endorse or recommend any investments and assumes no liability for any consequence relating directly or indirectly to any action or inaction taken based on the information contained in this article.