- A question facing investors who align their investments to ESG benchmarks is how their portfolios will perform in times of market stress. Recent events including the war in Ukraine have stressed markets and driven up energy prices, putting ESG factors under pressure.
- Investors are accustomed to considering risk and return as the two dimensions that guide asset allocation. As a result of our study, we find that two additional elements – time and preference – are needed to augment this process in an ESG world.
- The time element refers to the duration of the ESG transition underway as governments and companies enact regulations, new technologies, and investments to reduce pollution in line with the principles of the Paris Agreement and fulfill sustainable development goals relating to social responsibility and governance.
- 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.
- Our findings suggest that if investor preferences for sustainability are in line with the prevailing constraints for the investable universe, the tracking error and any trade-off in returns will be minimal; if the investor has very strong preferences and constrains the investable universe materially, there will be higher portfolio risk due to lower diversification. This results into higher required alpha to keep risk-adjusted returns the same.
- During recent periods of market stress, ESG indexes performed in line with traditional market benchmarks, despite great volatility in the energy sector.