Industry Voice: How smarter ESG integration can preserve your free lunch

Some investors value diversification, owning different assets so that risks aren't overly concentrated.

Meanwhile, many wish to reflect environmental, social, and governance (ESG) considerations in portfolios. But for some, excluding fossil fuels could mean excluding the entire energy sector.

In these terms, the objectives of diversification and of avoiding particular sectors because of ESG criteria appear contradictory.

We investigated this apparent conflict in order to quantify more accurately the relationship between negative screens and portfolio diversification in equities: put simply, are they friends or foes?

Sector inspector

We compared the correlation of each sector in the MSCI World index to that index to show the long-term diversification impact of each sector.

Table 1: Average five-year rolling correlations between MSCI World index sectors, 28.02.1995 to 28.06.2019

Source: LGIM, MSCI, Bloomberg

Some sectors, such as consumer staples (including tobacco) and healthcare, have consistently been diversifiers. However, correlations are dynamic; excluding sectors can expose investors to greater risk.

Weight watchers

When sectors are omitted from a market-cap portfolio, the way in which their index weight is redistributed among the other sectors could create unintended risks.

Table 2: Average sector overweights in MSCI World excluding Energy index (percentage points), 31.01.1995 to 28.06.2019

Source: LGIM, MSCI, Bloomberg

When energy is excluded, the largest overweights have been consumer discretionary, financials and technology, resulting in above-average beta.

We have focused on global developed market-cap exposure, with over 1,000 securities across more than 20 countries. For regional allocations, the impact of reweighting can be greater: in UK equities, three energy stocks from two issuers comprise over 15% of the FTSE 100. Excluding these could create a redistribution overweight to financials.

Matter of factor

We also looked at the factors (risk premia) of the energy sector over time.

The decline in the oil price led some to presume that negative screens systematically underweight value, but this is not the case. Recently, excluding energy has left portfolios underweight value; however, not long ago, quality and momentum were major forces in the energy index.

Investors may recently have been willing to forgo value exposure because of underperformance, but would they have wanted to minimise quality and momentum factors in previous market conditions?

Portfolio permutations

In summary, traditional negative screens may be appropriate for investors who must avoid certain sectors. But others could preserve diversification without sacrificing their ESG criteria, by integrating those criteria into their investment process in more nuanced ways. The exploration of innovative and effective ways to incorporate ESG is the focus of our current "Friend or Foe" research.

At Legal & General Investment Management, we believe ESG scoring provides a framework for engaging the companies in which we invest, and also allows us to tilt portfolios to reflect ESG criteria while maintaining diversification.

Important notice

Past performance is no guarantee of future results. The value of an investment and any income taken from it is not guaranteed and can go down as well as up, you may not get back the amount you originally invested. The Information in this document (a) is for information purposes only and we are not soliciting any action based on it, and (b) is not a recommendation to buy or sell

securities or pursue a particular investment strategy; and (c) is not investment, legal, regulatory or tax advice. Legal & General Investment Management Limited. Registered in England and Wales

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