3 ESG Risks That May Be Hiding in Your Portfolio
Unknown ESG-related risks may lead to unintended outcomes

How do ESG-related factors impact portfolios? Whether investors view themselves as an “ESG investor” or not, that is the question that is increasingly being asked. We analyzed a diverse set of 280 institutional portfolios with over $250+ billion in assets and identified important trends  investors should be aware of whether they are intentionally targeting ESG or not.

We compiled our findings in The Risk Report: ESG Special Edition. Below are three of those findings.

The Cancellation Effect Diluted Active Risk

Portfolios with higher ESG scores experienced a greater dilution of active risk, or the extent that investments deviate from the benchmark to drive potential outperformance. A cancellation effect, caused by offsetting exposures among underlying holdings, reduced the active risk of portfolios with higher ESG ratings by nearly 45% versus 35% for portfolios with lower ESG ratings.

What Is the Cancellation Effect?

The cancellation effect occurs when investment managers within a portfolio take opposing positions (e.g. sector bets, style tilts, etc.) that ultimately offset one another. For example, a manager might take a 3% overweight in a company while another manager takes a 3% underweight, effectively canceling each other out. Or there is a high-value bias in one strategy that is offset by a high-growth bias in another strategy.

While many portfolios we analyzed did not have specific ESG objectives, we found clear evidence of hiring ESG managers as “sleeved” or “satellite” allocations. Unfortunately, if there were any intended ESG outcomes in those scenarios, it rarely materialized at the portfolio level because of cancellation.

*Total manager active risk is the weighted average active risk of all underlying managers in the aggregate portfolio. The number illustrates what the aggregate portfolios’ total active risk would be if there was no cancellation effect among underlying managers (i.e. if the managers were perfectly correlated). **A portfolio was categorized as having a “high (low) ESG score” if its overall ESG score ranked in the top (bottom) quintile of all portfolios analyzed in our sample.
Source: Northern Trust Asset Management. Data as of December 31, 2021. Please note: Only portfolios containing two or more investment strategies were considered in the analysis for aggregate portfolio active risk.

Higher ESG Rated Portfolios Took More Uncompensated Risks

Only 40% of active risk in portfolios with higher ESG ratings come from ESG-related sources. Areas unrelated to ESG drove a significant amount of risk in higher ESG-rated portfolios. Consequently, they had a high exposure to risks not typically compensated with more return. Portfolios with higher ESG ratings had 15% more (usually uncompensated) active risk on sector and countries, which contributed to high-levels of uncompensated risk.

Further, portfolios with higher ESG ratings had significantly more exposure to high quality and low volatility compared to the average portfolio. While these style risks generally align with sources of excess return, their tilts to large size and low momentum are not.

Source: Northern Trust Asset Management. Data as of December 31, 2021. “Exposure” is measured by the z-score, which represents the number of standard deviations from the mean data set.

More Active Investing Lowered ESG Scores

Including active managers with higher active risk, tended to reduce portfolio ESG scores. The proportion of active versus passive investment strategies in a portfolio made a material difference in the overall ESG score. Most active strategies had a lower overall ESG score due to a significantly lower rating for the environmental pillar. Meanwhile, passive strategies tended to maintain, or even slightly improve, the ESG portfolio.

This may be explained by the increasing valuations for ESG leaders that have made active managers less willing to own them. Between 2018 and 2021, the price/book differential between ESG leaders and the MSCI World Index nearly doubled.^**

Source: Northern Trust Asset Management. Data as of December 31, 2021.
*Active investment strategies is defined as if the Active Risk of the manager relative to their stated benchmark is higher than 2.5%. The active MSCI ESG IVA Rating Score (%) used in above chart are averages across the Active and Passive portfolios from the sample set. ^**Top 20% of MSCI World stocks ranked by MSCI ESG IVA Rating score.

As sustainable investing continues increasing in demand, it is important for investors to understand potential unintended outcomes. There are additional findings available in the full ESG Risk Report. 

Download the ESG Risk Report.

About Sustainable Investing

At Northern Trust Asset Management (NTAM), we define Sustainable Investing as encompassing all of NTAM’s investment strategies and accounts that utilize values-based and norms-based screens, best-in-class and ESG integration, or thematic investing that may focus on a specific ESG issue such as climate risk. NTAM’s Sustainable Investing includes portfolios designed by NTAM as well as those portfolios managed to client-defined methodologies or screens. As the data, analytical models and aforementioned portfolio construction tools available in the marketplace have evolved over time, so too has NTAM. NTAM’s Sustainable Investing encompasses strategies and client assets managed in accordance with client-specified responsible investing terms (historically referred to as Socially Responsible), as well as portfolios that leverage contemporary approaches and datasets, including ESG analytics and ESG thematic investing.

NTAM may utilize an ESG framework in certain investment strategies. Considering ESG factors may result in reduced or increased exposure to certain companies or industries, which may cause the applicable strategy’s performance to be lower than that of strategies that do not consider ESG factors. In addition, the added cost of ESG-related diligence in assessing the ESG parameters of an investment may also reduce the profitability of an applicable strategy’s investments. There may also be different views of what it means for an issuer to have positive or negative ESG characteristics. There can be no guarantee that NTAM’s determinations regarding an issuer’s ESG characteristics will be accurate, including whether any such ESG characteristics are financially material or immaterial; any such inaccuracies could adversely affect a strategy’s performance.

IMPORTANT INFORMATION. For Asia-Pacific markets, this information is directed to institutional, professional and wholesale clients or investors only and should not be relied upon by retail clients or investors. The information is not intended for distribution or use by any person in any jurisdiction where such distribution would be contrary to local law or regulation. Northern Trust and its affiliates may have positions in and may effect transactions in the markets, contracts and related investments different than described in this information. This information is obtained from sources believed to be reliable, and its accuracy and completeness are not guaranteed. Information does not constitute a recommendation of any investment strategy, is not intended as investment advice and does not take into account all the circumstances of each investor. Opinions and forecasts discussed are those of the author, do not necessarily reflect the views of Northern Trust and are subject to change without notice.

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