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How Unintended Risks Make Their Way Into ESG Investment Strategies

Up to 70% of risk related to ESG is flying under the radar.

No asset management firm has spent as much time examining institutional portfolios for unintended risk than Northern Trust Asset Management, which recently completed a second massive research project on the topic. The original project, which debuted in 2019, looked across hundreds of institutional portfolios to unmask unintended risk. Very recently, the firm undertook a similar exercise targeting the unintended risks introduced into portfolios when asset allocators adopt ESG investment strategies.

Helping drive this effort at the firm has been Michael Hunstad, PhD, Head of Quantitative Strategies. According to Hunstad, the research has revealed a complex risk scenario brought about by ESG investing.

“Any time you tilt your portfolio toward ESG you inadvertently create multiple exposures to things such as sector biases,” says Hunstad. “In addition, you expose yourself to country and currency biases, and macroeconomic risks are transmitted through those biases. Certain sectors are exposed to interest rates, certain sectors are exposed to commodity price risk. What we found is that as you tilt your portfolio toward ESG, the risk that you’re taking that’s unintentional may actually dominate the intentional risk in the portfolio.”

The recently completed study revealed that on 70% of the risk emanating from ESG strategies is from unintended sources, which can at times overwhelm the performance of the portfolio. “Performance is skewed by these unintended bets, and that often leads to unexpected and unwanted outcomes. That indicates best practice in ESG portfolios is to control those unintended risks as close to zero as you possibly can,” says Hunstad.

How unintended risk piles up

One way that unintended risks pile up in ESG strategies might be called sector myopia. That is to say, a lack of diversification within a sector. It’s not uncommon, for example, within the energy sector for a portfolio to have an extreme bias toward advanced tech such as electric vehicles while completely ignoring other parts of the sector.

In that scenario, says Chris Vella, CIO, Multi-Manager Solutions, Northern Trust Asset Management, “you end up with a skewed portfolio that has no focus on alternative energy, which could be a big a diversified approach to that sector. That’s why we spend a lot of time making sure there are no unintended bets in a strategy.”

Similarly, according to Hunstad, a sharp focus on carbon reduction introduces unintended risk. A low-carbon portfolio tends to have lower exposures to utilities and the energy sector at large, which in and of themselves can create sources of risk in a portfolio – and, as previously mentioned, also act as a transmission mechanism for macroeconomic risks.

“One surprise many investors face when they allocate to a low-carbon portfolio is that because they are underweight energy and utilities, their portfolio is actually very sensitive to oil prices,” says Hunstad. “The result is an ostensibly safe portfolio from an ESG perspective that actually contains a lot of risk exacerbated by commodity price exposure. It’s a double-edged sword, because if you try to counter that effect and lower the volatility of your equities portfolio by taking on some other sector biases, such as materials, you may in fact increase the carbon footprint. It’s a very fine line that must be walked between carbon mitigation and risk mitigation, but sector biases, by and large, contribute very materially to the risk of a low-carbon portfolio.”

It’s a logical question to wonder how investors can assess the affect ESG might have on their portfolios. That’s the thing about unintended risk – you really don’t know it’s there unless you’re looking for it.  

“One of the best tools that we have at our disposal for assessing the impact ESG may have on the portfolio of our clients or prospects from a risk perspective is our proprietary portfolio factor analysis,” says Hunstad.  “It’s a process that essentially decomposes the portfolio into its risk and return drivers, inclusive of ESG considerations, and allows us to pinpoint which risks are intentional and compensated, and which are unintended and uncompensated. It’s a litmus test or a diagnostic, if you will, of the health of the portfolio at a given time.”

One of the things that often revealed by portfolio factor analyses is that the holistic risk in an ESG strategy is largely unknown to investors. “Investors expect they’ll have ESG content in their portfolio, but that ESG content may come packaged with a whole host of other risks that they know nothing about, ranging from sector and currency biases to country-based and idiosyncratic exposure. These risks can dominate the performance of the portfolio, and that has really come to a head during the two years of Covid-related volatility. Using our portfolio factor analysis, investors can take corrective action regarding those unintended risks.”

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Northern Trust Asset Management (“NTAM”) is composed of Northern Trust Investments, Inc. Northern Trust Global Investments Limited, Northern Trust Fund Managers (Ireland) Limited, Northern Trust Global Investments Japan, K.K, NT Global Advisors, Inc., 50 South Capital Advisors, LLC, Belvedere Advisors LLC and investment personnel of The Northern Trust Company of Hong Kong Limited and The Northern Trust Company.

The content provided herein is general in nature and is for informational purposes only. This information is not individualized and is not intended to serve as the primary or sole basis for investment decision making as there may be other factors to consider. You should conduct your own due diligence and analysis based on your specific needs. 

This communication is sponsored by NTAM and prepared by Institutional Investor. It is for your information only and is not an offer or solicitation for the purchase or sale of any security nor a recommendation or endorsement of any security or issuer. NTAM makes no representation about the accuracy, completeness, or timeliness of this information. 

This report is provided for informational purposes only and is not intended to be, and should not be construed as, an offer, solicitation or recommendation with respect to any transaction and should not be treated as legal advice, investment advice or tax advice. Recipients should not rely upon this information as a substitute for obtaining specific legal or tax advice from their own professional legal or tax advisors. References to specific securities and their issuers are for illustrative purposes only and are not intended and should not be interpreted as recommendations to purchase or sell such securities. Indices and trademarks are the property of their respective owners. Information is subject to change based on market or other conditions. 

An Environmental, Social and Governance (ESG) strategy’s use of ESG factors and screening process may screen out certain companies and industries and/or affect exposures to certain companies or industries. An ESG strategy utilizes ESG analytics as a risk mitigation tool not as an alpha driver and may cause the strategy to forego certain investment opportunities. Investors can integrate ESG data to create a more holistic view of risks and opportunities — resulting in more informed investment decisions and resilient portfolios.  

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