Research Affiliates: Trade-offs in climate and investment objectives

Research Affiliates: Trade-offs in climate and investment objectives

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By Ari Polychronopoulos, Head of Product Management and ESG at Research Affiliates

Investors with both social and investment objectives must make trade-offs in their portfolios. We examine a carbon reduction constraint on a value manager and conclude that investors should set realistic expectations in meeting dual objectives.

Client mandates can encompass competing objectives. Today, the competition is frequently between social and investment objectives. We examine trade-offs investors must be prepared to make in constructing a deep-value strategy concurrently with applying a carbon reduction constraint.

Practical trade-offs required

Because the primary source of GHG emissions is the burning of fossil fuels (highly correlated with certain types of business activity), an objective of a reduced-carbon profile leads to making significant active sector bets. The utilities and basic materials sectors account for nearly two-thirds of total annual emissions in the global developed markets.

A low-carbon investing objective necessarily and strongly pushes asset allocations away from utilities (and basic materials and energy) companies into technology (and telecom and financial) companies or other sectors with a low-carbon footprint.

In an environment in which very-high-carbon sectors become remarkably cheap, as in our study period from 2016 to 2021, a value investor with a decarbonization requirement struggles to maintain the desired position in undervalued companies.

The majority of value companies have a high level of carbon intensity (CI). On average, 7.2% of the 10% of the market value representing the deepest-value (highest composite valuation) companies have either high or very high CI when measured by revenues and 8.5% when measured by EVIC. From 2016 to 2021, only 3% or less on average of the total market value of the 10% deepest-value stocks had attractive valuations and below-average CI. The opportunity set is extremely limited.

Size and momentum suggest contrasting relationships with CI. Small-sized companies correlate strongly with deep-value companies because the size characteristic (market capitalization) is in the denominator of the fundamentals-to-market ratios. In contrast, high-momentum (high short-term return) stocks gravitate away from a deep-value classification as their prices outpace the trend of their fundamentals.

Our analysis shows CI is inversely related to company size, an intuitively appealing finding because larger companies have more resources to improve efficiency and increase productivity for each unit of carbon pollution.

A decarbonization process reallocates to companies with decreasing CI. Holding all else constant, this process sells companies with decreasing revenues or EVIC and buys those with increasing revenues or EVIC. Because the change in EVIC is driven mostly by the change in market capitalization, the decarbonization process resembles a strategy that buys stocks with strong momentum.

Lowering CI leads to larger size and stronger momentum characteristics in an investment portfolio. Both compete against classifying the portfolio as deep value.

Decarbonization portfolio analysis

As we describe in Necessary Trade-Offs: Climate vs. Investment Objectives for Value Strategies, my coauthors and I apply a simple, straightforward process for constructing a deep-value low-carbon strategy and demonstrate what such a portfolio would look like.

We show that the scarce availability of deep-value low-carbon companies leads a decarbonization bias in a value strategy and produces portfolios with high concentration and less-liquid holdings.

We also find that the common portfolio construction constraints that limit concentration and illiquidity make running a value strategy with a decarbonization objective more practical. When carbon reduction targets are measured using EVIC, however, 70% and 50% reduction targets cannot be met.

Doing good and doing well: is it possible?

An investor who seeks to concurrently satisfy a climate objective and an investment objective should consider relaxing the former while making practical adjustments to their preferred style- or factor-investing methodology.

For a CI reduction objective, one possible trade-off is to use revenues (or other fundamental metrics) as the denominator for the CI calculation, removing price in the formula can reduce the shift away from cheap stocks. The investor could also select a more-relevant benchmark, such as a value index, for the 30% or 50% carbon reduction target.

Only a detailed analysis of how to balance a social responsibility objective and an investment performance objective, followed by a thoughtful portfolio construction process, can help investors set realistic carbon reduction and investment goals to reach their preferred balance between ‘doing good’ and ‘doing well.’

Disclaimer: Please refer to our disclosures