Divesting from Energy: A Biased Approach?

Values-Aligned Investing
April 18, 2022

Aligning with energy values requires trade-offs on portfolio risk, return, and bias.

Divesting from oil and gas companies has long been an approach favored by investors concerned about climate change and the environment. While there are conflicting opinions as to the effectiveness of this approach in affecting change, divestment offers a way for investors to value-align their portfolios. Other tools are available to address these issues from a values perspective—scoring and tilting, proxy voting, shareholder advocacy, and carbon offsets to name a few—but divestment remains a popular option. The natural follow-up question is, “How does divestment impact the traditional financial characteristics of my portfolio?”

Volatility in the oil markets and large price moves among energy stocks tend to set investors on edge. When energy prices fall, interest around divesting from energy companies tends to increase from financially motivated investors. Conversely, when markets experience upside volatility, the questions shift toward whether divesting was the right (financial) move. Investors that divest to value-align their portfolios tend to get less caught up in these moves. That said, volatile periods in any sector can lead to swings in portfolio performance depending on whether a portfolio is overweight or underweight that sector.

While many such market dislocations occur over the lifespan of a portfolio, price shocks often mean-revert. Figure 1 below illustrates the cumulative returns of the MSCI All Country World Index (MSCI ACWI®), the MSCI ACWI ex Energy Sector, and the MSCI ACWI Energy Sector year to date (Figure 1A) and over the last 26 years (Figure 1B). The MSCI ACWI ex Energy uses a simple approach by excluding the Energy sector and scaling up the remaining exposures on a pro rata basis. In both cases, the MSCI ACWI and MSCI ACWI ex Energy scenarios experience very similar returns and volatility over time; however, the MSCI ACWI Energy portfolio, which consists only of the MSCI Energy sector, experiences multiple significant periods of volatility (both upside and downside).

Shorter term, some investors that have divested from energy companies might feel like they missed out on the rally in energy prices, but as the longer-term data shows, over 26-plus years, all three indexes have the same return (7.9% annualized), but the MSCI ACWI Energy Sector results a significantly more volatile experience.


Figure 1A: Cumulative total returns. MSCI ACWI Index, the MSCI ACWI ex Energy Sector, and the MSCI ACWI Energy Sector, year to date (daily data). Sources: Aperio and MSCI Barra Portfolio Manager.


Figure 1B: Cumulative total returns. MSCI ACWI Index, the MSCI ACWI ex Energy Sector, and the MSCI ACWI Energy Sector, over the past 26 years (monthly data). Sources: Aperio and MSCI Barra Portfolio Manager.


As it turns out, deciding whether to exclude energy companies (or any other type of company) is only the first step in building a values-aligned portfolio. Equally important is how you rebuild the portfolio afterwards. Recently published findings from Aperio’s research team1 indicate that how you reconstruct a portfolio impacts the ability to control for portfolio risk and potentially leads to unintended exposures.

Let’s use the MSCI ACWI as an example. The simple approach (excluding the Energy sector and grossing up the remaining exposures on a pro rata basis) results in a portfolio that exacerbates the effects of market-cap weighting. Larger companies have larger active weights, which results in a large-cap bias. Our research paper refers to this option as the simple portfolio, and as Figure 2 indicates, this approach overweights companies in the Financials and Information Technology sectors. This is because larger-cap companies are in the Financials and Information Technology sectors, and the large-cap bias increases their weight more than it increases those of other sectors when making up for the Energy exclusions.

Another option, the optimized portfolio, has the goal of minimizing forecast tracking error2 relative to MSCI ACWI and results in a significantly different portfolio. The optimized portfolio overweights companies, and thus sectors, that are the most highly correlated with the Energy sector. This is because the optimizer aims to replace the excluded Energy stocks with the next best alternative from a risk perspective. This leads to a correlation bias in the resulting portfolio that favors Utilities and Materials companies, leading to overweight exposures to those sectors, as shown in Figure 2 below.

Figure 2: Average active weights of Energy, Materials, Utilities, Financials, and Information Technology sectors in simple and optimized scenarios where the Energy sector has been excluded. Benchmarked to the MSCI ACWI Index. August 1995–December 2020. Sources: Aperio and MSCI Barra Portfolio Manager.


It is important that a client looking to divest from energy companies understands that they will likely have an overweight to companies in these sectors due to the correlation bias. Clients that are uncomfortable with these potentially unintended exposures can apply additional exclusionary criteria to further value-align their portfolios. It’s all about increasing awareness of and setting expectations around the impact of exclusions on a portfolio.3

Looking at the two different construction methods, we ask ourselves how these biases impact a portfolio’s risk and return over time. The team’s research finds that over the 25 years through 2020, the optimization approach achieves a tighter tracking error to the benchmark than the simple approach while delivering index-like risk and return characteristics.

Figure 3: Performance of simple and optimized energy exclusion strategies benchmarked to the MSCI ACWI Index. August 1995-–December 2020. Forecast data are point-in-time calculations not intended to provide any assurance as to future performance or any limit on losses. Should any underlying factors, such as volatility, change, that will alter the forecast tracking error, potentially significantly. Sources: Aperio and MSCI Barra Portfolio Manager.


Whether an investor decides to divest from energy companies or not, and whether their motivation for divesting from energy companies is driven by values, financial concerns, or other reasons, the research is clear—how you reconstitute a portfolio post-exclusion can impact its biases and long-term risk and return characteristics. Aperio’s optimized approach to portfolio construction aims to minimize the impact exclusions have on performance (relative to a benchmark), and for clients looking to incorporate values by applying exclusionary criteria, understanding the trade-offs is critical.


Send questions or comments to aperio.blog@blackrock.com.


Important Notes:
The MSCI® Indexes referenced herein are the registered trademarks of MSCI or its subsidiaries in the U.S. and other jurisdictions and are used by Aperio under license. No Aperio strategy is sponsored, endorsed, or promoted by MSCI, and MSCI bears no liability with respect to any such strategies, or any MSCI index upon which such strategies are based.  Aperio’s license agreement with MSCI contains more details of the limited relationship MSCI has with Aperio and any related strategies.  No further distribution of data from any MSCI index is permitted without MSCI’s express written consent.

1 Jeffrey R. Bohn, Lisa R. Goldberg, and Simge Ulucam, “Sustainable Investing from a Practitioner’s Viewpoint: What’s in Your ESG Portfolio?” Journal of Investment Management (forthcoming).

"Forecast tracking error” is a measure of how a portfolio might perform in comparison to a benchmark given various risk factors as of a certain date. The calculation is based on data related to portfolio holdings, benchmark holdings, and risk model data as of a particular date. It is not intended to provide any assurance as to future performance or any limit on losses. Should any underlying factors, such as volatility, change, that will alter the forecast tracking error, potentially significantly.

Ben Schneider, “ESG Exclusions: Setting Expectations,” November 12, 2018, Aperio blog.


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