Strategies for climate-proofing portfolios
Benchmark optimization is just one strategy for potentially climate-proofing portfolios. Other climate-aware investing methods include investing in benchmarks that take climate into account or proactively investing in climate-aware companies. 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, according to our simulations and analysis.
Bottom line: We believe there is little downside to gradually incorporating climate-change awareness into the investment process—and even potential upside.
Market Realist – ESG’s three dimensions
In our series Take a Look at the Road Map for Climate-Savvy Investing, we discussed the importance of ESG (environmental, social, and governance) scores in investing and how bearing these factors in mind can help climate-proof one’s portfolio.
Incorporating ESG factors into an investment process can imply two things: creating additional returns and reducing the portfolio’s volatility and downside risks. The three-dimensional view of ESG is environmental, social, and governance. Various studies have been conducted to understand the relationship between these factors and stock performance (IWM), as you can see in the chart above.
However, a 2013 Hermes study revealed that out of the three dimensions, the corporate governance factor acts as a primary driver for stock performance (SPY) (VOO). The study investigated the performance of companies in the MSCI World Index (ACWI) from December 31, 2008, to November 30, 2013.
Importance of corporate governance
The corporate governance factors include board independence, remuneration, independent directors, risk management, and business ethics. The Hermes study saw a strong relationship between the ESG score and corporate governance.
The chart above shows how companies’ corporate governance drives the ESG score. A 2014 meta-analysis study published by the University of Oxford and Arabesque Asset Management also supported the theory that the integration of ESG factors into investment decisions drives stock performance positively. Higher ESG scores lead to better stock price performance compared to firms with low scores.
Looking ahead at the adverse effects of climate change, climate-proofing portfolios should be an essential consideration for all asset owners. Hence, incorporating climate-change awareness into the investment process can be beneficial to investors.