Avoid ESG tail risks to help generate alpha, new research shows

New research by Allianz Global Investors, one of the world’s leading active investment managers has found that avoiding environmental, social and governance (ESG) tail risks is a more effective strategy to help generate alpha over a full market cycle, than tilting a portfolio towards top ESG ratings.

The research, undertaken in-house, looked at three different areas related to ESG risk factors including their effect on risk and reward; type of ESG risk; and value-add of active investing and stewardship through corporate engagement and proxy voting.

The research found yielded three clear results:

1. ESG factors matter for downside risks

The findings confirm academic research on ESG that simply skewing portfolios to better ESG risk scoring holdings does not generate higher returns. AllianzGI’s research shows that portfolios skewed to a worse ESG risk profile can show significantly more financial portfolio tail-risk vs. the benchmark.

2. Manage the low ESG-rated holdings

The research also found that investments with a higher ESG risk scoring delivered a very similar risk profile when compared to the benchmark. But this is not the case when it comes to low ESG risk-rated portfolios, with a significant difference in the lower tranche, indicating the need to address ESG as a source of tail risk through fundamental research and active management. Managing low ESG-rated holdings is more relevant for compound returns than tilting towards high ESG-rated companies in portfolios.

3. Active management is key

The research provided further evidence that investors should not solely rely on investing in companies with high ESG ratings or avoiding high ESG risk holdings. It demonstratesthat a simple passive or tilted ESG strategy would actually overpay by concentrating assets without an additional return. To fully address ESG risks, there are a host of ESG factors that investors must pay attention to in the future, including constantly changing macro and regulatory dynamics, as well as corporate fundamentals, market and political events.

Passive rules-based ESG index strategies can be challenged as the performance of ESG investment indices is often driven by unintended factor changes. Although the performance impact of active stewardship through corporate engagement and proxy voting is hard to measure in the short term, there is good evidence that it adds value in the mid-term.

Steffen Hörter, Global Head of ESG at Allianz Global Investors and co-author of the study, comments: “Even though our findings indicate that ESG risk can signal material financial downside, overall avoidance of ESG risk per se is not the answer either. While accounting for ES&G factors in your investment portfolio may not boost its upward performance, it could be an effective source to generate alpha by helping to manage downside risks. Avoiding large portfolio draw-downs by ESG risk management can help contribute to better risk-adjusted returns.

It is important that ESG risk is not about average portfolio risk, but about extreme events that are financially material and stem from an ESG-related source. We are convinced that active managers who make a judgemental risk/reward trade-off on ESG risks will prove their worth to investors, in comparison to the simple ESG portfolio tilts we have seen in the passive investment industry.”