New paper out from researchers at Robeco, a Dutch asset manager, in the most recent issue of the Financial Analysts Journal, addressing the question – is it optimal to constrain your portfolio from holding companies engaged in undesirable activities (e.g. carbon energy production), or can investors incorporate sustainability measures as part of the portfolio’s objectives?
Titled '3D Investing: Jointly Optimizing Return, Risk, and Sustainability,' the authors seek to answer the question:
“…is investing targeting a sustainability objective alongside risk and return objectives superior to traditional investing augmented by sustainability constraints?”
Most of us pursue the latter with a strategic asset allocation (the amount of our portfolio in stocks, bonds, cash and possibly alternative investments like impact funds) that meets our long-term risk and return requirements, then apply restriction to the resulting portfolio to prevent it from containing specific companies and activities (negative screens is by far the most used tool among faith investors, from our recent Good Intentions study, nearly 75% of faith asset owners employ “screening”, well beyond any other method – i.e. positive screens, impact, advocacy, etc). Instead, can we establish a strategic asset allocation that incorporates sustainability in a positive way?
It's likely that your investment consultant, manager or advisor used a “mean-variance optimization” (MVO) model to help establish the strategic asset allocation for your portfolio. There’s a lot of math involved, it’s nearly impossible to find an introduction to MVO without immediately jumping into equations, but its goal is to essentially find the portfolio mix of asset classes that produces the desired expected outcome of investment return and investment risk --- by definition, it “optimizes” along these two dimensions – return and risk.
The authors of this article ask; can we add a third dimension, sustainability, to arrive at an asset allocation that optimizes all three?
As expected, there’s a significant amount of math and data in the paper, explaining and applying the methodology the authors employ, which they apply under two scenarios, comparing traditional “2D” risk and return based asset allocation combined with constraints and restrictions applied to the resulting portfolio, and their new “3D” approach which incorporates a sustainability goal into the asset allocation process:
1. Reducing the total carbon footprint of a portfolio
2. Improving the SDG score of a portfolio
Their findings are meaningful, as shown in the charts below.
On carbon footprint reduction, the authors find that a “3D” portfolio optimized including a carbon footprint reduction (green line) had a significantly smaller carbon footprint relative to a traditional “2D”“constrained and restricted” portfolio (orange/blue line), without a meaningful difference in risk or return.
On SDG improvement, the results were similar, “3D” portfolios incorporating an overall SDG objective (green line) were significantly better than “2D constrained and restricted” portfolio at improving the SDG profile of the resulting optimal portfolio, with similar risk and return results.
Broad Applications and Higher Returns
Overall, the authors find that 'The 3D investing framework is generalizable to any sustainability metric that can be expressed as a discrete or continuous series.' Across a number of scenarios tested, they conclude that '3D investing achieves, on average, higher sustainability characteristics and expected returns when compared with a pure constraint-based approach.' We will pick up this work with asset managers and investment consultants, and watch for further academic research and practical applications in this promising area of sustainable investment.
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