Overweighting and underweighting
One approach is to optimize benchmarks for climate factors. This means overweighting green companies and underweighting climate offenders while keeping a portfolio’s return profile close to the benchmark. Smallish portfolio tweaks can make a big difference in reducing climate-change risks, as evident in this week’s chart.
It is possible, for example, to cut a portfolio’s carbon emissions by around 70% while keeping the tracking error (the deviation of returns from the benchmark over time) within 0.3% annually. See the chart below.
Market Realist – What’s important for investors?
Before looking at options to climate-proof a portfolio, investors should first consider their motivation. Do they intend just to protect their portfolios from climate-change impact, or do they want to take advantage of a lower-carbon economy? Incorporating climate considerations does not necessarily imply one has to sacrifice on stock returns (IWM).
In our series Take a Look at the Road Map for Climate-Savvy Investing, we looked at benchmarks like the MSCI ACWI Low Carbon Target Index and the MSCI ACWI Ex-Fossil Fuels Index, which take the climate factor into account. These indexes have the potential to perform in line with or better than regular counterparts, and they have outperformed the ACWI World Index (ACWI) (IVV).
As we discussed in Part 1, overweighting green companies and underweighting companies with the lowest importance to climate factors can make a difference in avoiding climate risks. As evident in the graph above, a simulation conducted by the BlackRock Investment Institute showed that small tweaks could make a big impact.
A climate-friendly portfolio with a high ESG (environmental, social, and governance) score can provide more benefits. Research shows that companies that have reduced their carbon footprints have outperformed their peers. The simulation revealed that the new portfolio with 70% fewer CO2 emissions had a better ESG score. The biggest sector changes occurred in energy (IYE), consumer staples (IYK), and consumer discretionary (XLY).
In the final part of this series, we’ll look at the strategies for climate-proofing portfolios.