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Searching for Greener Pastures

Risk, Performance, and Reporting

By Pat Reilly  |  September 25, 2019

There I was after Labor Day, nursing a hellacious sunburn after a weekend on Lake Travis, wondering where it went wrong. Lack of sunscreen and a hat were the easy answers. Texas summers are hot and sunny, but were they always this hot and sunny? In my discomfort, I took it to a more existential place. What about the cause of and fallout of Hurricane Dorian and the storms to follow? Or the upcoming fire season in the American West?

So I did what any analytical product specialist would do on a slow Tuesday—“crunched some numbers” on my portfolio to get a sense of my exposure to climate change (outside of the aforementioned sunburn—and no, I was not confident that it would turn into a tan).

I’ve previously written about ESG as it relates to insurance company general accounts and its application to fixed income securities and portfolios. However, I’ve never run my own portfolio to understand my exposures on the ESG front nor have I tried to green up my holdings. It seemed like as good a time as any to analyze what I own, both implicitly and explicitly. Park the asset allocation conversation and table the social and governance pillars this go around. This Climate Week, let’s do a deep dive on the environmental pillar.

I’ve broken my analysis into three sections. First is ESG Integration 101, where I group my portfolio by asset class and sector while introducing scores and ratings from a third-party provider. Second, I compare results across third-party providers to understand their gaps and differences. Finally, I’ll conclude by swapping several positions with similar products branded as green or ESG to see how my overall scores change. Let’s get started!

ESG Integration 101

Where do you start trying to understand your holdings in the context of ESG? Figure 1 illustrates that my discretionary portfolio is core in nature. I maintain an income tilt while diversifying across market capitalizations and between developed and emerging markets. I will revisit the asset allocation in a follow-up article.

Portfolio Weights

My first step was to incorporate a third-party provider with my portfolio. On platform, we integrate MSCI, Sustainalytics, RepRisk, and Trucost with Arabesque in the queue. In this exercise, I started with MSCI. We will incorporate Sustainalytics and Trucost in the next section.

Figure 2 reports exposure for my overall portfolio as well as individual ETFs. I added the ESG columns of interest and refreshed Portfolio Analysis. This step is where I see clients and prospects waste hours trying to link data sources, identifiers, and meta data.

More Detailed Portfoltio Weights

Picking the analysis back up, what did I want to measure? I started with basic scores around climate change, natural resource use, and pollution. Utilizing a GICS sector mapping, I learned that nearly 10% of my portfolio was in energy, automobiles, materials, transportation, and capital goods that typically have lower relative environmental scores. While Figure 3 highlights how these holdings act as a drag on the environmental scores relative to the rest of the book, I think it is important to note that there are still great names in these industries, some may even be a fit for a green portfolio. ESG is not built solely around negative screens or exclusionary investment policy statements.

Even more details portfolio weights

Because these are ETFs, my exposure is passive. Managing to a strict ESG mandate on an individual portfolio constructed in this manner can be challenging, as I will illustrate later.  

So far, we have looked at scores from MSCI. There are several other providers that have low hurdles to integration. Let’s add Sustainalytics and Trucost to the mix to see how the results change.

Which Provider Should You Choose?

That’s a loaded question and one I cannot answer for you or your firm without a deeper discussion. Coverage, research, and methodology are just a few factors you will want to consider as you look at ESG data providers. What I can do is present score and exposure detail for multiple providers across a globally diversified book of securities to provide examples of the differences that may be seen between sources.

Figure 4 indicates that MSCI and Sustainalytics are on different scales when viewing the Environmental Pillar Score. Scale aside, my portfolio scores higher under Sustainalytics, primarily due to the EM debt, European, Indian, and Small Cap exposure. Scale is just one example where methodology make comparisons across providers difficult.

weights 4

Now suppose we wanted to drill down further into carbon emissions. Scope 1 emissions are generally defined as those from sources owned or controlled by the company and are typically measured in metric tons. Figure 5 compares these figures using MSCI and Trucost. While the numbers are similar in terms of magnitude, the differences at an ETF level further highlight how methodology may vary across providers. There is no panacea.

weights 5

A Certain Shade of Green

Up to now we’ve seen how easy it can be to glean insight into what your environmental impact and exposure looks like across asset classes and third-party providers. But what if we wanted to model out transactions to take a more environmentally friendly stance?

I will skip the portfolio construction process steps of screening, optimization, pre-trade compliance, etc. and conduct a simple product swap from IVV, IEV, INDY, MCHI, FM, and IJT to ESGU, ESGD, ESGE, and ESML to maintain a similar asset allocation. How does that shift the narrative?

Diving into Figure 6, we can see that my exposure to automobiles and energy dropped while my exposure to materials and transportation had small increases. It was surprising that shifting so much of the portfolio to ESG-branded passive products did not impact the sector/industry exposure more definitively. It also indicates that while it is easy to integrate ESG concepts into the analysis, portfolio construction requires far more thought to really move the needle.

Weights 6

But how did this product swap impact my exposure scores? Comparing Figure 3 with Figure 7, my new portfolio scores higher across all major categories. A skeptic might point out that these are minor changes (e.g., the pre-trade Carbon Emissions score was 8.13 while the post-trade increased to 8.30). The important takeaway is that managing scores and exposures can be done easily, even in a passive environment for retail investors.

weights 7

Next Steps

I could take any number of steps from here. For starters, I could overhaul the entire portfolio using active or passive vehicles. Or I could build my own portfolio from scratch using a screening and optimization approach. Had I been producing my own independent ESG research, I could integrate that into my analysis as another data point. I could also integrate governance and social pillars from providers to refine risk management or pursue values-based investing. Data integration truly is step one, but now that I know what I own, the creation of actionable items is within reach.

Until next time, keep wearing that sunscreen!

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Pat Reilly, CFA

Vice President, Director, Americas Analytics

Pat Reilly has 15 years of experience within the investment management industry focusing on fixed income. Prior to joining FactSet, Pat started his professional path as a Credit Manager at Wells Fargo and then as an Investment Services Analyst at Pacific Life. He earned a Bachelor of Science, Finance from the Eller College of Management at the University of Arizona and a Master of Business Administration from the Marshall School of Business at the University of Southern California.

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