Volume 20, No. 4, Fourth Quarter 2022
ESG Investing II
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Practitioner's Digest
Practitioner’s Digest • Vol. 20, No. 4
The “Practitioners Digest” emphasizes the practical significance of manuscripts featured in the “Insights” and “Articles” sections of the journal. Readers who are interested in extracting the practical value of an article, or who are simply looking for a summary, may look to this section.
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Article
Carbon Emissions and Asset Management
Two common methods that portfolio managers use to reduce the carbon footprint of their portfolios are either to exclude carbon emitters from their portfolios or to engage/cajole underlying companies to reduce their carbon footprint by taking actions to reduce emissions. We estimate the costs of excluding carbon emitters from a portfolio. We highlight the costs and benefits of a third alternative that seeks to preserve the separation principle such that managers select their optimal portfolio based on return and risk optimizations, and separately incur transaction costs to satisfy investors’ demands toward “net zero” by purchasing carbon credits to offset the carbon footprint of their optimal portfolios. By doing so, although the composition of the portfolio may contain carbon emitters, the portfolio itself is carbon neutral. To acquire these carbon credits efficiently either directly or in secondary markets requires asset management skills. We believe that investors in mutual funds or ETFs would determine their own preferences toward carbon “net zero” by buying a combination of a fund that offsets fully emissions of the companies in the underlying portfolio and another(a clone of the other)that did not.
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Article
ESG Investment Performance Evaluation: An Integrated Approach
ESG investment strategies have experienced a massive inflow of capital over the past decade despite investors having few methods to evaluate their performance and communicate their ESG values, objectives, and preferences to investment managers. This paper develops a three-dimensional performance evaluation metric that incorporates return, risk, and ESG outcomes. It is predicated on an investor’s willingness to trade off financial gain for non-financial gain and can accommodate any traditional riskadjusted performance measure. Withoutsuch frameworks, investors can neither determine whether outcomes match their expectations nor compare performance across managers and allocate capital accordingly.
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Article
Factor Investing in Paris: Managing Climate Change Risk in Portfolio Construction
The 2015 Paris Agreement is a landmark in limiting emissions and targeting global warming well below 2◦C, preferably 1.5◦C compared to pre-industrial levels. In this light, we investigate how to efficiently construct equity portfolios that help mitigating climate change risk but at the same time enable harvesting well-established return drivers such as value, momentum or quality. A pure reduction in greenhouse gas intensity or a divestment from fossil fuel sectors is not necessarily leading to a better temperature alignment of a portfolio. Given the limited set of temperature-aligned assets, keeping the average temperature increase below 2 degrees comes with considerable active risks. To this end, we propose a net zero portfolio construction framework that brings temperature alignment together with a reduction in carbon intensity while harvesting equity factor premia.
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Article
Climate-Aware Risk Budgeting
Climate change is a risk investors are thinking about, but how can it be practically incorporated into an asset allocation framework? This paper presents two different approaches. One is a traditional approach where the covariance matrix and excess return vector is adjusted to account for climate change. More detail is given for a second approach, a risk-budgeting approach. In this approach, investors adjust their risk budgets based on climate change information.
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Article
ESG Screening in the Fixed-Income Universe
This paper evaluates the impact of a screening process based on Environmental, Social, and Governance (ESG) scores for an otherwise passive portfolio of investment-grade corporate bonds. The main result is that a global exclusion strategy leads to a substantial improvement of the targeted ESG score without reducing the risk-adjusted performance but with significant biases in regional, sectoral, and risk factor exposures. We demonstrate that a best-in-class strategy implemented at the regional and sectoral levels allows investors to eliminate undesirable regional and sectoral exposures while delivering similar ESG scores and risk-adjusted performances.
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Insight
Bias and Noise in Humans & AI: When to Trust Humans & Machines in Decision-Making .
When should we trust machine-based and human decisions in finance? In this article I answer this question by drawing on two sets of insights about decision error. I first draw on research of leading theorists on human decision-making and prediction, summarized through a set of articles and conversations with them about the two sources of decision error, namely, bias and noise. I also draw on two decades of experience operating a machine-learning based trading platform, where algorithmic bias and noise also manifest themselves, but very differently than in human decision-making. This two-pronged analysis of the properties of humans and algorithmic decision-making provides a backdrop against which the challenges and opportunities for creating trustable decision-making systems in finance come into sharp focus.
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Case Study
ESG Greenwashing and Recent Sec Actions
“Case Studies” presents a case pertinent to contemporary issues and events in investment management. Insightful and provocative questions are posed at the end of each case to challenge the reader. Each case is an invitation to the critical thinking and pragmatic problem solving that are so fundamental to the practice of investment management.
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Book Review
Where the Money Is: Value Investing in the Digital Age
“Book Reviews” identifies important, and often popular, new books from a wide range of investment topics. Beyond providing a summary and review of the content and style of the books, “Book Reviews” seeks to contribute to a conscious, critical, and informed approach to investment literature.