Robeco logo

Disclaimer

Please read this important information before proceeding further. It contains legal and regulatory notices relevant to the information contained on this website.

The information contained in the Website is NOT FOR RETAIL CLIENTS – The information contained in the Website is solely intended for professional investors, defined as investors which (1) qualify as professional clients within the meaning of the Markets in Financial Instruments Directive (MiFID), (2) have requested to be treated as professional clients within the meaning of the MiFID or (3) are authorised to receive such information under any other applicable laws. The value of the investments may fluctuate. Past performance is no guarantee of future results. Investors may not get back the amount originally invested. Neither Robeco Institutional Asset Management B.V. nor any of its affiliates guarantees the performance or the future returns of any investments. If the currency in which the past performance is displayed differs from the currency of the country in which you reside, then you should be aware that due to exchange rate fluctuations the performance shown may increase or decrease if converted into your local currency.

Robeco Institutional Asset Management UK Limited (“RIAM UK”) markets the Funds of Robeco Institutional Asset Management B.V. (“ROBECO”) to institutional clients and professional investors only. Private investors seeking information about the Robeco Funds should consult with an Independent Financial Adviser. ROBECO will not be liable for any damages or losses suffered by private investors accessing the website.

RIAM UK is an authorised distributor for ROBECO Funds in the UK and has marketing approval for the funds listed on the website, all of which are UCITS Funds. ROBECO is authorised by the AFM and subject to limited regulation by the Financial Conduct Authority.

Many of the protections provided by the United Kingdom regulatory framework may not apply to investments in ROBECO Funds, including access to the Financial Services Compensation Scheme and the Financial Ombudsman Service. No representation, warranty or undertaking is given as to the accuracy or completeness of the information on this website.

If you are not an institutional client or professional investor, you should therefore not proceed. By proceeding, please note that we will be treating you as a professional client for regulatory purposes and you agree to be bound by our terms and conditions.

If you do not accept these terms and conditions, as well as the terms of use of the website, please do not continue to use or access any pages on this website.

Decline

06-09-2023 · Insight

Mind the gap: Effectively replacing sustainability exclusions

Sustainable investors commonly exclude the least sustainable companies, but in doing so create a gap in the portfolio. Our latest research compares various methods to replace these excluded stocks.

    Authors

  • David Blitz - Chief Researcher

    David Blitz

    Chief Researcher

  • Nick Mutsaers - Researcher

    Nick Mutsaers

    Researcher

  • Maarten Jansen - Researcher

    Maarten Jansen

    Researcher

Summary

  1. Excluding unsustainable stocks leaves a gap that needs to be filled

  2. Naïve rescaling of the remaining stocks is inefficient, research shows

  3. We aim for better performance by using more sophisticated approaches

Creating a gap

When it comes to sustainable investing, common examples of exclusions include the tobacco industry, companies involved with controversial weapons and thermal coal producers. However, exclusions can also be implicit, such as constraints on the carbon footprint or ESG score of the portfolio which necessitate divesting from certain stocks that score poorly on these metrics.

These exclusions result in underweight positions compared to the market portfolio, leaving a gap to be filled. In order to remain fully invested, sustainable investors must replace such underweights with overweight positions in other stocks. There are several ways to go about this, each with its own pros and cons. Since active decision making is required, sustainable investing is, by its nature, active investing; see also Blitz and de Groot (2019). The purpose of our recent research is to compare the financial performance of various methods used to replace excluded stocks.

Three approaches

The base-case, ‘naïve’ approach is to rescale the weights of remaining stocks in proportion to their market capitalizations. One concern is that this method can inadvertently bet against proven factors. Another issue is that rescaling often replaces stocks like utilities companies with heavyweight tech stocks like Apple, Microsoft, and Alphabet, introducing significant tracking error.

Our first alternative approach aims to minimize the tracking error resulting from exclusions, striving to realign closely with the return of the market index. The second alternative uses the forced underweights from exclusions to buy stocks with attractive factor characteristics, with the goal of maximizing risk-adjusted returns. In the appendix to our research we also explore a third alternative, which involves replacing exclusions with highly sustainable stocks, using alternative energy stocks as a concrete example.

Methodology and findings

For our empirical analyses, we consider two types of exclusions: carbon footprint constraints and exclusions based on Sustainable Development Goal (SDG) scores. For the carbon footprint constraint, we explore reductions of 50%, 60%, 70%, or 80% compared to the benchmark index. The SDG data is drawn from Robeco’s proprietary SDG framework, with scores ranging from -3 (worst) to +3 (best). Our sample encompasses the MSCI World (developed markets) universe from January 2006 to December 2022.


For instance, portfolios with exclusions underperformed by 2 to 4% in 2022 alone

Our initial analysis shows that the naïve approach doesn't significantly affect long-term performance, but it does introduce a large amount of tracking error. For instance, portfolios with exclusions underperformed by 2 to 4% in 2022 alone, and over periods of two to five years, such exclusions can even lead to return differences of more than 10%.

We then deploy our two advanced approaches: one minimizing tracking error and the other maximizing return. The former reduces tracking error by 50-70% for carbon constraints and 30-50% for SDG exclusions. The latter focuses on maximizing factor exposure, leading to net information ratios of about 1, signifying decent outperformances. Figure 1 compares these approaches in terms of carbon constraint and Figure 2 in terms of SDG exclusions.

Figure 1: Conditional performance of portfolios with carbon constraints

Figure 1: Conditional performance of portfolios with carbon constraints

Source: Robeco

Figure 2: Conditional performance of portfolios with SDG exclusions

Figure 2: Conditional performance of portfolios with SDG exclusions

Source: Robeco

We find that compared to the naïve approach, both alternatives are less sensitive to various market environments. The return-optimized portfolios, in particular, manage to achieve positive expected returns in almost every scenario.

Conclusion

Sustainable investing involves exclusions that require careful portfolio rebalancing. Our research suggests that a simple rescaling approach can be inefficient and introduces unnecessary risk. However, more sophisticated approaches, either minimizing tracking error or maximizing returns, can significantly improve performance.

Read the full article


Robeco

Robeco aims to enable its clients to achieve their financial and sustainability goals by providing superior investment returns and solutions.

Important information This disclaimer applies to any documents and the verbal or written comments of any person in presentations or webinars on this website and taken together is referred to herein as the “Information”. The services to which the Information relate are NOT FOR RETAIL CLIENTS - The information contained in the Website is solely intended for professional investors, defined as investors which (1) qualify as professional clients within the meaning of the Markets in Financial Instruments Directive (MiFID), (2) have requested to be treated as professional clients within the meaning of the MiFID or (3) are authorized to receive such information under any other applicable laws and must not be relied or acted upon by any other persons. This Information does not constitute an offer to sell, or a solicitation of an offer to buy, any financial product, and may not be relied upon in connection with the purchase or sale of any financial product. You are cautioned against using this Information as the basis for making a decision to purchase any financial product. To the extent that you rely on the Information in connection with any investment decision, you do so at your own risk. The Information does not purport to be complete on any topic addressed. The Information may contain data or analysis prepared by third parties and no representation or warranty about the accuracy of such data or analysis is provided.
In all cases where historical performance is presented, please note that past performance is not a reliable indicator of future results and should not be relied upon as the basis for making an investment decision. Investors may not get back the amount originally invested. Neither Robeco Institutional Asset Management B.V. nor any of its affiliates guarantees the performance or the future returns of any investments. If the currency in which the past performance is displayed differs from the currency of the country in which you reside, then you should be aware that due to exchange rate fluctuations the performance shown may increase or decrease if converted into your local currency. Robeco Institutional Asset Management B.V. (“Robeco”) expressly prohibits any redistribution of the Information without the prior written consent of Robeco. The Information is not intended for distribution to, or use by, any person or entity in any jurisdiction or country where such distribution or use is contrary to law, rule or regulation. Certain information contained in the Information includes calculations or figures that have been prepared internally and have not been audited or verified by a third party. Use of different methods for preparing, calculating or presenting information may lead to different results. Robeco Institutional Asset Management UK Limited (“RIAM UK”) is authorised and regulated by the Financial Conduct Authority. RIAM UK, 30 Fenchurch Street, Part Level 8, London EC3M 3BD (FCA Reference No:1007814). The company is registered in England and Wales under Ref No. 15362605.

In all cases where historical performance is presented, please note that past performance is not a reliable indicator of future results and should not be relied upon as the basis for making an investment decision. Investors may not get back the amount originally invested. Neither Robeco Institutional Asset Management B.V. nor any of its affiliates guarantees the performance or the future returns of any investments. If the currency in which the past performance is displayed differs from the currency of the country in which you reside, then you should be aware that due to exchange rate fluctuations the performance shown may increase or decrease if converted into your local currency. Robeco Institutional Asset Management B.V. (“Robeco”) expressly prohibits any redistribution of the Information without the prior written consent of Robeco. The Information is not intended for distribution to, or use by, any person or entity in any jurisdiction or country where such distribution or use is contrary to law, rule or regulation. Certain information contained in the Information includes calculations or figures that have been prepared internally and have not been audited or verified by a third party. Use of different methods for preparing, calculating or presenting information may lead to different results. Robeco Institutional Asset Management B.V. is authorised as a manager of UCITS and AIFs by the Netherlands Authority for the Financial Markets and subject to limited regulation in the UK by the Financial Conduct Authority. Details about the extent of our regulation by the Financial Conduct Authority are available from us on request.