Carbon-Efficient Portfolio Construction Part 1: Unconstrained Versus Sector Relative

As more institutions start to adopt low-carbon investing into their investment processes, it’s important to understand portfolio implications of incorporating carbon risk. We recently published a research paper in which we demonstrated how carbon efficiency can be integrated into factor portfolios. In a series of blog posts, we will be discussing our findings.

We evaluated carbon-efficient investment portfolios from various angles: improvement in weighted average carbon intensity, risk/return profile, sector allocation, and active risk exposures. The carbon intensity data, provided by Trucost, part of S&P Dow Jones Indices, were defined as greenhouse gas (GHG) emissions measured in tons of carbon dioxide equivalent per USD 1 million of revenue (CO2e/USD 1 million).

Sector-unconstrained, carbon-efficient portfolios were formed by ranking stocks in the whole universe (across sectors) based on individual companies’ carbon intensity and grouping them into quintile portfolios.[1] The most carbon-efficient portfolio, Quintile 1, lowered the carbon intensity by 95% to 14 CO2e/USD 1 million from the S&P United States LargeMidCap benchmark (see Exhibit 1). However, on an absolute return basis, Quintile 1 underperformed most of its peers, except for Quintile 5 and the underlying benchmark. In addition, the Quintile 1 portfolio had the highest volatility among all the portfolios, thereby resulting in the lowest risk-adjusted return.

We further analyzed the sector composition and attribution of the unconstrained carbon-efficiency portfolios to explore potential sector biases relative to the underlying benchmark and their impacts on portfolio efficiency.

The average sector weights of Quintile 1 showed that, on average, it had a significant overweight in the financials sector, with an average overweight of 45.29% (see Exhibit 2). The portfolio also had a substantial underweight in the energy, consumer staples, and industrials sectors.

The overweight in financials contributed substantially to the negative active returns of the portfolio relative to the benchmark (see Exhibit 3). From June 2007 to December 2017, the allocation to the financials sector detracted an annualized return of approximately 2.39% from the portfolio’s performance versus 0.43% for the benchmark on a monthly average basis.

Analysis of risk exposures showed that the sector-unconstrained, carbon-efficiency portfolio had positive active exposures to beta, value, liquidity, price volatility, and high leverage. On the other hand, it had large negative active exposures to yield, size, earnings growth, earnings variability, and momentum (see Exhibit 4).[2] Active exposure is defined as the difference between portfolio exposure and benchmark exposure. Therefore, during the back-tested period, the unconstrained carbon-efficient portfolio tended to have lower exposure to quality and higher exposure to value than the benchmark.

The results from Exhibits 2, 3, and 4 confirmed that the unconstrained carbon-efficient portfolio had significant unintended (and unfavorable) sector and risk factor tilts that dragged down the performance. In the next blog, we will continue to discuss how to potentially address these issues.

[1] B. Hao, A. Soe, and K. Tang. “Carbon Risk Integration in Factor Portfolios.” 2018.

[2] We used the Northfield U.S. Fundamental Risk Model to estimate the risk exposure.

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