Reconciling sustainability, market performance and customer risk appetite

By Aymeric Kalife, CEO at iDigital Partners & Adjunct Professor at Paris Dauphine University - PSL

An asset with a high ESG score (devised by major ratings agencies,
such as MSCI, Morningstar, LSE) means good sustainability practices within the company: among the E,S and G factors.

• The Environment factors refer to the behaviour on environmental issues such as resource depletions, climate change, pollution;• The Social factors are related to the treatment regarding people, workers and local communities, including health and safety;• The Governance factors refer to corporate policies and governance, including tax strategy, corruption, structure, remuneration.Adherence to ESG criteria should help minimize downside risk in a firm’s financial performance (and thereby its stock price), based on
the premise that ESG-compliant firms are likely to be well-managed overall.

A high ESG score is thus likely to help a company to (i) attract more investors, (ii) lower the cost of capital, and (iii) result in better operational performance thus stock performance.

Therefore the ESG score is becoming an increasingly key factor in a portfolio asset allocation, The ESG AuM is expected to reach $50tn by 2025 (a third of Global AuM) within the context of growing customers ‘demand and regulatory requirements (for example in the insurance industry). Actually, ESG is of most relevance to long-term products with an investment component, primarily unit-link and pension savings products and to a lesser extent with-profits products.

Aymeric Kalife

CEO at iDigital Partners

& Adjunct Professor at Paris Dauphine University - PSL

Although ESG is still today primarily used in the initial screening process, it is expected to become a bigger driver of investment decisions over time. Nearly 80% of respondents say ESG factors have caused them to limit exposure to or divest entirely from particular assets: tobacco companies, arms manufacturers and companies in the extraction, power, and real estate sectors due to climate change.

Regarding market performance, market timing usually plays a key role for ESG assets:

• Offering Downside protection during sustained crisis (2008, 2020)

• Driving performance in the long run (Europe, North America

• Used as Beta in Europe and Alpha strategy in the US

• But with volatile performance trends: underperformed in 2010-13 then outperformed

ESG vs.
market performance

Still, regarding the literature review, reconciling market performance and sustainability remains an open issue, with no conclusive statistical statistics, findings and conclusions highly conflicting and with no clear answer.

Reconciling Sustainability, market performance and Customers’ Risk Appetite though an ESG risk-based optimal asset allocation

Here we focus on one-year performance using weekly returns. This study covers a period from January 4th, 2010 to December 27th, 2019 across Europe. The studied companies are selected from the Stoxx600.

Although a naive diversification based on equally weighted best ESG stocks portfolio provides over time a positive trend in performance relative to the benchmark, and some outperformance during specific periods (e.g. 2020 market crash) or in the long term, it still most often underperforms worst ESG stocks portfolios over shorter time horizons (e.g. 1-year) in terms of overall absolute returns, risk-adjusted metrics (e.g. Sharpe or Sortino ratios), and VaR/CVaR:

The lower performance of ESG stocks portfolios under such a naïve asset allocation mostly stems from the ESG screening that tends to reduce diversification, as measured by the “Diversification Ratio” and the “Diversification measure”.

As a result, a upgraded asset allocation is devised by integrating the ESG constraints directly into the Markowitz approach.First we make sure that all required modelling assumptions are passed by econometrics tests (regarding the non-autocorrelation, the normality and the non-heteroscedasticity of returns), as illustrated below

Then an optimal asset allocation is built based on a nonlinear Markowitz program upgraded by the ESG scoring and some risk criteria illustrative of the customer’s Risk Appetite (e.g. volatility, Value-at-Risk, Conditional-Value-at-Risk), as follows:

Specifically maximizing the absolute returns under two constraints: a minimum ESG score and a maximum Value-at-Risk. Given the multiple constraints, the optimal asset allocation involves a nonconvex optimization, which requires the combination of a global stochastic evolutionary algorithm with a local deterministic nonlinear algorithm.

It turns out to deliver a clear and resilient outperformance in terms of overall returns, risk, and cost of capital, to the benefit of both customers and insurance companies. More specifically:

a higher excess returns and downside Sharpe ratio (Sortino ratio) since 2016
the Net selectivity (= the alpha – the Diversification measure) is now positive and 4 times better for the best ESG than for the worst ESG assets
a lower downside deviation since 2013

The results can be further improved across all asset management KPIs and KRIs, in both magnitude and duration (since the availability of ESG data) by introducing “hybrid” ESG scoring metrics instead of a plain ESG scoring metrics, which combines both ESG scoring AND corporate finance KPIs (e.g. debt or EBITDA metrics).