A recent white paper from Refinitiv and Probability & Partners considers how a portfolio can be created that significantly improves sustainability, without sacrificing financial performance.
- Existing portfolio creation methodologies limit the potential of improving portfolio sustainability while maintaining performance.
- A new approach provides portfolio strategies that maximise and minimise ESG scores and minimum return requirements.
- These strategies can increase portfolio sustainability without reducing financial performance, and create portfolios that perform above the benchmark.
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The white paper, Three Dimensions in Portfolio Selection: return, risk and sustainability, authored by Ying Wu and Svetlana Borovkova at Probability & Partners, discusses how ESG parameters can be incorporated into equity investment portfolios.
It notes the limitations of using mean-variance optimisation for portfolio allocation, and classical portfolio optimisation that selects stocks and optimises only portfolio weights. Instead, it reviews a new, yet relatively simple, approach.
Relationship between sustainability and financial performance
The approach adds sustainability considerations at the stock selection stage. Within this approach, the paper presents two strategies that examine the relationship between sustainability and financial performance:
- Strategy 1 – A sustainability metric of the stock portfolio, in this case the ESG score, is maximised and a minimum return requirement is imposed
- Strategy 2 – The portfolio return is maximised and a minimum ESG score requirement is imposed.
Portfolio volatility is not directly optimised, but is partially controlled by an appropriate sector diversification.
The white paper finds that the strategies of maximising ESG with a minimum return requirement and maximising return with a minimum ESG requirement can achieve the balance of increasing the sustainability of a portfolio without reducing financial performance.
This is the case in the European Union and UK, where results are superior to the benchmark, In the U.S., results do not differ significantly from the benchmark.
There are also slight variations in outcomes depending on index and inputs such as parameters and portfolio size, but overall the research demonstrates that increasing the ESG elements of a portfolio does not necessarily reduce returns.