Home / Russell designs risk-lite carbon diet for equity investors

Russell Investments has cooked up a new hybrid model designed to burn-off carbon from global equities portfolios without contaminating underlying risk profiles.

In a paper published last month – request paper here Russell laid out a proposal to help institutional equity investors comply with the United Nation-backed Principles for Responsible Investment (PRI) September 2014 Montréal Carbon Pledge, which to date has about US$100 billion of assets committed to the strategy, and the goals of the Portfolio Decarbonisation Coalition.

The Russell paper compares three common decarbonisation strategies – divestment, sector neutral reallocation and risk model optimisation – while introducing its own approach to the problem.

According to Russell, given that the global carbon footprint tends to clump around a small number of firms – in a trend consistent across regions and sectors – decarbonising an equity portfolio becomes “a relatively simple task”.

“The trick is to do it while maintaining benchmark-like portfolio characteristics and returns,” the paper says.

However, Russell says the three common carbon-scrubbing strategies typically inject new risks into share portfolios.

For example, the paper says while risk model optimisation does follow most index metrics “its excess return is substantial and is reflective of benchmark-relative risks”.

“These risks are also present in the Divestment and Sector Neutral Reallocation strategies, as indicated by their higher tracking errors and drawdowns. Our expectation is that these risks are due to sector exposures and asset-level positions,” Russell says. “…”[Russell’s decarbonisation method] aims to preserve the strengths of all the approaches and minimise the biases.”

The report says while the three existing carbon-slashing methods have outperformed over the last five years, the underlying risks may have been underestimated.

“The concern is that these excess returns are driven by systematic sector tilts that aren’t expected to reliably pay off. The virtue – that they have paid off over the most recent five years – is only a coincidence, and we have no expectation for it to persist,” the paper says. “But we do expect the systematic tilt to persist. That leaves Divestment and Risk Model Optimisation exposed to the precise sectors we expect might reverse over the next several years. Even if they don’t reverse, both strategies are unnecessarily exposed to these sectors. We feel this is a dimension of risk worth controlling for.”

Russell says its approach should at least half the aggregate carbon footprint of the benchmark while maintaining “low active risk, low active share, low exposure to sectors, industries and countries”.

“We believe decarbonisation is a unique problem that requires a unique solution. While investors are looking to encourage decarbonisation, they still have a fiduciary commitment to deliver on return expectations,” the paper says. “This strategy emphasises a divestment approach while also incorporating security, sector and country constraints to effectively manage active risk and ensure that fiduciary obligations are met.”

Russell developed the strategy while designing a bespoke decarbonisation solution for the A$30 billion plus Australian industry superannuation fund HESTA last year.

Earlier this year, AMP Capital called for better carbon disclosure from listed firms in a paper authored by the fund manager’s Australian-based head of ESG research, Ian Woods.

– David Chaplin, Investment News NZ