Full tilt: the role of ESG in strategic asset allocation


The environmental, social and governance (ESG) ratings of investments, such as their levels of exposure to climate risks and carbon emissions, have become important to global institutional investors. However, the integration of an ESG preference in the strategic asset allocation (SAA) – “ESG tilting” – requires reflection.

SAA consists of setting target allocations at asset class level and periodically rebalancing the portfolio. Each asset class is assigned an assumed average return and variance, and an efficient frontier is then constructed to determine the optimal investment strategy for any specified level of portfolio risk, such that the highest expected return is reached for this level of risk.

We cannot simply perceive one asset class as being more ESG-friendly than another, for example investment grade corporate bonds versus high yield corporate bonds. On the other hand, we know that the ESG shift will reshape the profile of our asset classes in two respects:

  • At the industrial sector level, the weights of the most carbon-intensive sectors will likely be reduced in an ESG-oriented asset class. Since the risk / return differs considerably from sector to sector, such sector reweighting will result in a change in risk / return for each of these asset classes, and a different SAA result.
  • In terms of security, there will be trade-offs between the most ESG-friendly securities and the most effective in terms of risk / return. Such trade-offs become more evident when the two cohorts diverge substantially, and become more complicated when we are faced with the task of selecting a limited number of stocks and determining their weights from a large index.

Establishing ESG-oriented assumptions is quite complicated in practice. For example, our credit analysts may indicate that there are only several hundred corporate bonds in our “investment universe”, and our final portfolio may contain less than 100 bonds due to the limit of. wallet size. If we want the key attributes (duration, quality, solvency capital requirement, sector weightings except carbon intensive ones) of our final portfolio to stay close to the index, and we want some ESG tilt, there will be complex optimization mechanisms. How do I perform a fine calibration?

ESG switchover in practice

We will use a real world example to show how ESG tilt at SAA level can be implemented using a linear optimizer. Our example is based on investment grade corporate bonds – typically the most important asset class for an insurer, and for which there is often a wealth of ESG information available.

The first step is to identify the investment universe, which for simplicity we will assume the entire ICE BofA US Corporate index (C0A0), containing around 9,100 bonds. The main attributes broken down by industry level are shown in Table 1.

The index volatility of 4.9% is calculated by blending sector volatilities using a correlation matrix, all calibrated using historical total return data.

You will notice that there are a few very carbon intensive industrial sectors (highlighted in green), but otherwise the scores for the ESG and climate change themes are similar. If we halve the weights of these carbon-intensive sectors and distribute the excess weights in proportion to the rest, the characteristics of the index are presented in Table 1 row B).

To better reflect the multi-step filtering process in portfolio construction, we use a linear optimizer to build a model portfolio (MP) with the objective of maximizing current yield, and the following constraints:

  • The duration, rating and concentration of issuers must be broadly the same as the original index
  • Keep 60% of the stocks in the index
  • Industry sector weights should be within ± 5% of index sector weights, with the exception of carbon intensive sectors which we have adjusted
  • The scores for the ESG and climate change themes must each be improved by at least 10%
  • Carbon intensity must be reduced by at least 30%.

The results portfolio – row C) – has the attributes indicated in Table 1.

As an optional final step, suppose that, unlike the simplified assumption we made for sector weight adjustments, our credit analysts told us that the investment universe is only a small fraction. of the index – several hundred bonds. Our final portfolio (MP ‘) must then be measured against this very small starting point.

A similar model portfolio “optimized for yield, but not for ESG” is constructed in the same way, except that only the constraints of the non-ESG directives are used:

  • The duration, rating and concentration of issuers must be broadly the same as the original index
  • Keep 60% of the stocks in the index
  • Industry sector weights must be within ± 5% of the index sector weights.

The expected return assumption of our ESG-oriented investment grade corporate bond asset class is calculated as follows:

RESG-inclined index = Origin index + (RMP – RMP ‘)

By repeating these steps for all asset classes, we have the risk / return assumptions we need for an ESG oriented SAA. If we focus only on credit asset classes (where ESG information is more readily available), this typically still covers over 50% of a typical insurance balance sheet.

We believe that our ESG approach to strategic asset allocation offers a practical solution to establishing an efficient frontier with improved ESG ratings.

Notes for Table 1:

* Worst Return: The lowest possible return an investor could receive on a bond that does not default.

** Carbon intensity is the volume of carbon emissions (tonnes of CO2) per million dollars invested for device assets.

*** The climate change theme score (on a scale of 0 to 10) is the weighted average of all attributes related to the climate risk of the emitter, including carbon emissions, energy efficiency, carbon footprint of the emitter. product, climate change risk insurance and environmental impact financing.

Ziling Jiang is responsible for insurance analysis, EMEA at Neuberger Berman

Cyril Bosse-Platière is an insurance strategist at Neuberger Berman

Image credit | Getty


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