Our Fundamental Factor Team manages outcome-oriented strategies. By outcome, we mean a specific expected return profile, which we pursue using active managers, actively managed multi-factor strategies, or a combination of the two. For example, clients with defensive equity objectives often look for a specific beta or downside capture profile, and those with equity income objectives typically seek a high expected income or targeted distribution yield (i.e., payout).

With a growing number of clients looking for ways to integrate climate risk into their portfolios, we are often asked how their pursuit of outcomes like defensiveness and income, whether via systematic or fundamental approaches, will be affected by their simultaneous pursuit of carbon goals. To analyze the impact on the broad opportunity set and determine whether there would have to be some compromise on other intended biases in a portfolio, we conducted an in-depth carbon-integration study. Here we provide a brief overview of the study and our key conclusions.

Our research approach

In our analysis, we used MSCI data, given the broad coverage of the equity universe, and the metric we focused on is the weighted average carbon intensity (WACI), which normalizes tons of carbon emissions per dollar of sales at the company level and allows for benchmark-relative comparison. To limit the number of variables, we wanted to focus the analysis on a single region and, importantly, one where a below-benchmark WACI could not be achieved by simply removing one or two of the worst offenders in the universe. In other words, we set the bar high for the analysis to provide a realistic sense of the trade-offs between striving for carbon goals and pursuing the desired portfolio outcome.

We applied the standard revenue-based exclusions used at our firm, which relate to climate risk and, specifically, greenhouse gas emissions (e.g., thermal coal mining > 10% of revenue). Ultimately, we chose Europe for our analysis because the exclusions did not remove any stocks from the opportunity set there and, as a result, would not reduce the carbon-intensity starting point when building a Europe-focused strategy. With this as our starting point, we then looked at the impact of integrating carbon goals in both systematic and fundamental strategies.

Carbon goals in systematic strategies

We used an optimization process to create income-oriented and defensive portfolios from the MSCI Europe Index, and then tested the impact of constraining the optimizations by building portfolios with different benchmark-relative carbon intensity levels.¹ The intent was to determine the impact on the broad opportunity set (not to build an active strategy) assuming reasonable portfolio construction rules (i.e., you can’t just allocate 25% to a low-WACI stock and sell the 25 worst offenders). We would welcome the opportunity to share additional detail on our assumptions and constraints, but for our purposes here we have summarized our findings on the degree of conflict between carbon-intensity objectives and the income-generation or defensive goals:

• We found that income is generally a space with high relative carbon intensity. Thus, as we moved from a baseline portfolio with no carbon constraint to portfolios with greater carbon constraints, we saw a steadily decreasing yield.
  
• We also looked at the impact on factor and sector exposures. We found that as carbon constraints rose, portfolios became less overweight value and less underweight growth and quality. And at the sector level, they became less overweight materials, energy, and utilities, and less underweight health care, industrials, and consumer discretionary.
• Compared with income, integrating carbon constraints in defensive portfolios (i.e., portfolios targeting minimum absolute volatility) did not meaningfully limit the opportunity set until the constraints became more restrictive.
• With defensive portfolios, the impact on fundamental characteristics was minimal until carbon constraints became more aggressive, but we still saw a similar pattern as with income: Greater constraints eventually led to less value exposure and more growth/quality exposure. At the sector level, there was some shift away from utilities and materials, but it was less significant than with income.

These results are generally intuitive. There are inherent skews to carbon intensity across sectors, with energy, utilities, and materials having the highest carbon intensity. For income strategies, these sectors are fruitful hunting grounds today. Defensive strategies, on the other hand, may tend to have more sector diversification and a wider opportunity set.

Carbon goals in fundamental strategies

For our study of fundamental strategies, we stayed with our European universe and picked two representative active strategies to model the impact of carbon constraints on stock selection and conviction. Again, we can provide additional details on our methodology but in short, we tested whether carbon constraints can have a significant impact on stock selection in active fundamental portfolios. Our hypothesis was that an active manager would need to change the conviction in a portfolio (either by changing stock weights materially or through stock substitution) to meet carbon objectives if handled through portfolio construction alone. Unlike in systematic strategies, where substitution can be relatively seamless, for fundamental stock-picking strategies there can be a substantial cost to substitution, given the research investment built up over time.

Among our key findings:

• Defensive objectives had fewer conflicts with carbon constraints than income objectives.
• The stock selection alpha profile for the fundamental income strategy was materially compromised at much lower carbon constraint levels than the fundamental defensive strategy. (This result lines up with the systematic results noted earlier.)
• With increasing carbon constraints, unintended style tilts toward growth and quality and away from value showed up, but to a much lesser degree than in our systematic study.

Taking these findings into account, we believe it is best to avoid the use of an independent systematic process “overlay” on a single fundamental active portfolio to reach carbon goals, as it could have a significant impact on an individual fundamental manager’s portfolio sizing and, therefore, conviction. However, we have found that in multi-manager approaches, where there is a wider breadth of ideas to select from, carbon constraints can potentially be integrated into the aggregate portfolio more easily and without causing the disruptions that can occur when they are integrated at the sleeve level.

¹Wellington selected the assumptions and portfolios used in this analysis at its discretion. The use of alternative assumptions or portfolios would yield different results. Past results are not indicative of future results.

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