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Aligning equity multifactor strategies with net zero objectives


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    Investing in ways that contribute to net zero greenhouse gas emissions by 2050 and beyond is increasingly a concern for most investors, in particular institutional investors. For this reason, we have studied various approaches to aligning our multifactor equity strategies with net zero objectives.  

    In our most recent paper, “Equity Factor Investing with Paris Aligned constraints”, we give insights into applying Paris Aligned Benchmark (PAB)-type constraints to multifactor equity investing and we investigate the impact of imposing the minimum requirements and voluntary criteria in the European Union regulation on PABs on the expected returns and risk of multifactor equity strategies.

    Multiple possibilities to align the multifactor strategy

    We explored various approaches to render the multifactor portfolio ‘Paris-aligned’.

    First, just changing the benchmark from a traditional market capitalisation-weighted index to a PAB is not sufficient to align the multifactor strategy. In fact, we could have just changed the benchmark and kept the original multifactor portfolio. That would likely result in a higher tracking error versus the benchmark as well as failure to align the strategy with net zero objectives.

    Indeed, alignment constraints must be applied directly to the portfolio itself (changing the benchmark is just optional). Accordingly, we applied the alignment constraints in the EU regulation on PABs to the portfolio, making no further changes and keeping the original market cap-weighted benchmark and investment universe in place.

    This approach suits investors who continue to benchmark performance against traditional market cap-weighted indices in terms of expected returns and risk. We used portfolio optimisation to minimise the impact of the alignment constraints on the original exposure of the portfolio to the value, quality, low risk and momentum factors, i.e., on the drivers of performance in this strategy.

    While imposing alignment constraints on the portfolio is a necessary condition, we could also consider replacing the market cap-weighted benchmark with a PAB and/or limiting the investment universe to the constituents of the PAB.

    In our paper, we investigated all these possibilities, always using portfolio optimisation to minimise the impact of constraints on the original factor exposures driving the performance of the multifactor portfolio.

    Avoiding historical simulations

    The traditional approach used by quantitative managers to address questions about expected returns and risk is to construct historical simulations of what the strategies would have generated in the past. However, relevant company carbon emissions data lacks historical depth, making it difficult to construct historical simulations without introducing strong approximations.

    Moreover, such simulations would not consider changes in regulations, technological advances and shifts in market sentiment related to the need to decarbonise the economy. Finally, the dynamic nature of the actual PAB constraints with regards to decarbonisation pathways makes it almost irrelevant to use historical simulation methods.

    Instead, we opted for a simpler approach that sheds light on the expected impact of PAB-type constraints now and in the short to medium term. This is based on investigating how the PAB-type constraints change the targeted factor exposures that drive the expected performance and risk of the portfolio. In our paper, we describe the methodology to run this analysis on a given date.

    The recommendations

    Overall, we found that imposing PAB-type constraints directly on a multifactor portfolio while keeping the market cap-weighted index as the benchmark and as the investment universe is the most effective approach to aligning the portfolio while minimising the impact on expected returns and risk.

    In fact, the minimum requirements of the EU PAB regulation have hardly any impact. We also found that only specific voluntary criteria could affect expected returns.

    Even changing the benchmark to a PAB to manage the tracking error is not expected to affect the expected returns of the portfolio significantly if we apply only the minimum PAB requirements, and the portfolio is not constrained to invest only in stocks in the PAB index.

    Beyond PAB-type constraints

    In our paper, “Aligning Investments with the Paris Agreement: Frameworks for A Net Zero Pathway”, we compared four different frameworks for net zero investing: 

    • A forward-looking approach Net Zero Achieving, Aligned, Aligning (AAA) screens
    • The Paris Aligned Benchmark (PAB) rules
    • Fossil fuel exclusions
    • Clean energy thematic investing. 

    The approach followed here for PAB-aligned multifactor equity investing could also be applied to gain insights into how the other frameworks would impact the expected returns and risk of multifactor portfolios.


    Please note that articles may contain technical language. For this reason, they may not be suitable for readers without professional investment experience. Any views expressed here are those of the author as of the date of publication, are based on available information, and are subject to change without notice. Individual portfolio management teams may hold different views and may take different investment decisions for different clients. This document does not constitute investment advice. The value of investments and the income they generate may go down as well as up and it is possible that investors will not recover their initial outlay. Past performance is no guarantee for future returns. Investing in emerging markets, or specialised or restricted sectors is likely to be subject to a higher-than-average volatility due to a high degree of concentration, greater uncertainty because less information is available, there is less liquidity or due to greater sensitivity to changes in market conditions (social, political and economic conditions). Some emerging markets offer less security than the majority of international developed markets. For this reason, services for portfolio transactions, liquidation and conservation on behalf of funds invested in emerging markets may carry greater risk.
    Environmental, social and governance (ESG) investment risk: The lack of common or harmonised definitions and labels integrating ESG and sustainability criteria at EU level may result in different approaches by managers when setting ESG objectives. This also means that it may be difficult to compare strategies integrating ESG and sustainability criteria to the extent that the selection and weightings applied to select investments may be based on metrics that may share the same name but have different underlying meanings. In evaluating a security based on the ESG and sustainability criteria, the Investment Manager may also use data sources provided by external ESG research providers. Given the evolving nature of ESG, these data sources may for the time being be incomplete, inaccurate or unavailable. Applying responsible business conduct standards in the investment process may lead to the exclusion of securities of certain issuers. Consequently, (the Sub-Fund's) performance may at times be better or worse than the performance of relatable funds that do not apply such standards.

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