Another approach is to optimize benchmarks for climate factors. This means overweighting green companies and underweighting climate offenders while keeping a portfolio’s return profile as close to the benchmark as possible. An even more proactive approach is to invest in climate-aware companies that use resources efficiently, mitigate weather-related risks and exploit climate opportunities. Our research has found that U.S. companies with higher climate scores—our measure of companies’ resource efficiency and exposure to climate-change related risks and opportunities—tend to be more profitable and generate higher returns on assets.
Bottom line: We see climate-proofing portfolios as a key consideration for all investors.
Market Realist – How do ESG scores matter?
An ESG (environmental, social, and governance) score is mainly used to measure the sustainability and ethical impacts of investing in a company. A company’s ESG score is based on its annual disclosure of various metrics in its CSR (Corporate Social Responsibility) report. These metrics include total GHG (greenhouse gas emissions) and the percentage of independent directors. The integration of ESG scores into the investment process can help diversify portfolio risk.
A 2015 Harvard study suggested that companies should understand the relevance of ESG factors and accordingly incorporate them into their operations. Incorporating ESG factors could help businesses generate the best shareholder value.
Optimizing benchmarks for climate factors
In the above graph, you can see the cumulative index performance (or gross returns) of the MSCI USA ESG Select Index with the traditional MSCI USA Index. The MSCI USA ESG Select Index (KLD) acts as a benchmark for investors who are looking for an investment opportunity with a very high ESG score and controlled risk. This index has risk and returns characteristics similar to the MSCI USA Index (USMV). However, it provides exposure to companies with a positive ESG score. This index overweights companies with high ESG ratings and underweights companies with low scores.
The information technology (QQQ) (IYW), healthcare (IYH) (XLV), and financials (XLFS) (IYF) sectors make up 54% of the total weight of the MSCI USA ESG Select Index. Research has indicated that the integration of ESG scores in stock selection for portfolios has helped reduce overall equity portfolio risks, especially regarding lower volatility. Other research has shown the financial benefits of incorporating the ESG factors into investment strategies, showing a positive relationship between higher ESG scores and better stock performance (SPY) (VOO).
What we can conclude here is that climate awareness is an important factor that you may want to consider. Climate-proofing your portfolio could benefit you in the short term as well as the long term.