In this article, the authors explore six quantitative environmental (E), social (S), and governance (G) strategies to provide insights into best practices for ESG portfolio construction. These strategies offer different approaches to the trade-off between desired ESG attributes and investment performance. They conclude that fully understanding the dynamics of these trade-offs will allow investors to select the strategy that best matches their ethical and financial views.
Highfliers Drive Market Returns. Losers Drive Tax Alpha.
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Free Is a Dangerous Word (Especially during a Pandemic)
by Patrick Geddes & Dan SpierIn the past 18 months, we’ve witnessed some extraordinary changes in how retail stock investors trade, from the broad shift for many brokerage firms toward zero commissions to the jump in trading by individuals in 2020, presumably a result of the pandemic...
Investors often ask us about the expected impact of certain socially responsible (SRI/ESG) constraints on the risk and performance of a portfolio. In our earlier work, we explored several different approaches for constructing a custom SRI/ESG portfolio to help frame that discussion. Here we take a closer look at short- and long-horizon impacts of a popular industry exclusion when using an optimizer to construct portfolios.
Aperio's investment process seeks to create a diversified equity portfolio that looks and behaves like its benchmark while still respecting SRI/ESG objectives. As a result, portfolios that exclude a specific industry will tend to redeploy that capital in other industries whose fundamental and economic risks are similar to the divested industry’s.
In our earlier work, we referred to this approach as the “Optimized Exclusion” strategy in order to contrast it clearly with a naïve reweighting approach (“Cap-Weighted Exclusion”). The latter approach is simple: it does not require a risk model nor an optimizer. While we expect this approach to outperform if the excluded securities underperform, it also may lead to excessive forecast tracking error.
In contrast, we expect our optimized approach to “cushion” the negative performance impact that could occur when an industry that has been excluded outperforms. However, because other industries are not perfect substitutes for the excluded industry, we expect the customized portfolio to have some amount of variation around the benchmark’s performance. We use forecast tracking error as the primary gauge of how much a portfolio’s performance could vary from its benchmark.
For example, investors who excluded the Oil, Gas & Consumable Fuels (OGCF) industry generally experienced underperformance relative to standard (market-capitalization weighted) benchmarks such as the MSCI ACWI in Q2 2018. To illustrate this, we simulated the historical performance of a nontaxable portfolio with an OGCF exclusion.
If we look at the next quarter’s performance (Q3 2018), we see that the situation has reversed and the custom portfolio outperformed its benchmark, erasing all of the underperformance in Q2.
A quarter is a very short time period to evaluate the performance of a strategy. (Research* has shown that checking performance too often increases the likelihood of making suboptimal investment decisions.) So we examined the performance of the same custom portfolio as far back as 2008. The following chart shows the correlation of the active returns of the custom portfolio against the active returns of the OGCF industry.
While there is a fluctuation in the magnitude of the historical correlation, it is pretty clear that a portfolio that excludes the OGCF industry will generally underperform when the OGCF industry outperforms (the correlation is generally negative).
Aperio’s approach to portfolio construction tries to minimize the impact on performance (relative to a benchmark) from an exclusion, but it cannot completely eliminate it as a driver of risk and return. This is reflected in summary risk statistics such as forecast tracking error, which provides a general guide for the expected magnitude of deviation around a benchmark but does not indicate whether the potential deviations will be positive or negative.
This material is not intended to be relied upon as a forecast, research or investment advice, and is not a recommendation, offer or solicitation to buy or sell any securities or to adopt any investment strategy. The opinions expressed are as of the date of publication and may change as subsequent conditions vary. The information and opinions contained in this post are derived from proprietary and non-proprietary sources deemed by BlackRock [Aperio] to be reliable, are not necessarily all-inclusive and are not guaranteed as to accuracy. As such, no warranty of accuracy or reliability is given and no responsibility arising in any other way for errors and omissions (including responsibility to any person by reason of negligence) is accepted by BlackRock, its officers, employees or agents. This post may contain “forward-looking” information that is not purely historical in nature. Such information may include, among other things, projections and forecasts. There is no guarantee that any forecasts made will come to pass. Reliance upon information in this post is at the sole discretion of the reader.
Aperio is providing this link to a third-party website that displays a research report, article, webcast, video, or other content that we believe may be informational or educational for you. This linked content is presented by a source that we believe to be reliable, but we do not guarantee its accuracy or completeness, including any associated disclosures. Aperio has no control over the nature of the content on, or the availability of, this third-party website.
The inclusion of this link on our website also does not imply a recommendation or endorsement of any views expressed in such linked content and should not be considered: investment, tax, or legal advice; a solicitation; a recommendation of Aperio or any third-party’s services; or an offer to buy or sell any securities or related financial instruments in any jurisdiction.
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Ben Schneider, CFA
Investment Strategist and Tax Economist
What are your key responsibilities? As an Investment Strategist and Tax Economist at Aperio, I support and advise clients on asset allocation, taxes, risk management, and other complex investment questions. I also work closely with the portfolio management and research team to develop analytical tools and materials that help our clients understand the trade-offs of various investment decisions.
Describe your key previous work experience. Before Aperio, I worked as an Investment Strategist for BlackRock, Inc.’s systematic global macro hedge fund and discretionary tactical asset allocation teams, where I supported BlackRock’s strategic institutional partnerships in the United States, Asia, and South America. I was also responsible for developing software to support signal research and target risk optimization for multi-asset, long/short investment strategies. Previously, I worked as an Investment Banking Analyst at Lazard Ltd.
Describe some noteworthy projects you have worked on that directly impact Aperio’s clients. While strategists typically focus on the non-investment support we provide clients, sometimes we get to contribute to the investment process too. One example is the work we’ve done on American depositary receipt fees. In addition to providing some insight into the trade-offs among the different ways to get exposure to non-US companies, we also use the output of that work to shape our investible universe and reduce transaction costs for our investors.
What are some non-work-related things we should know about you? I enjoy yoga, swimming, and kiteboarding.
What postsecondary degrees and/or professional certifications do you possess? BS in Business Administration from the University of Southern California; MBA in Accounting from the USC Marshall School of Business; MFE from the University of California, Berkeley, Haas School of Business.
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