SSGA: Investors Should Use Optimization When Constructing Reduced-Carbon Portfolios

More investors are constructing portfolios with environmental, social, and governance principles in mind. This includes explicit carbon-reduction targets, temperature alignment goals, and climate objectives such as mitigation and adaption.

So, State Street Global Advisors constructed and back-tested five equity portfolios targeting carbon reduction, varying across risk and return dimensions. Of the five portfolios that SSGA constructed, two used a screening approach, two used a tilting approach, and one used an optimization approach.

  • Divest 10 (screened): The 10% highest carbon emitters in the MSCI World Index universe are removed (i.e., 10% of market cap is removed).
  • Divest 20 (screened): The 20% highest carbon emitters in the MSCI World Index universe are removed (i.e., 20% of market cap is removed).
  • Pure Tilting: A simple tilt is applied on carbon intensity with no constraints applied.
  • Iterative Tilting: A cumulative normal distribution is applied to carbon emissions, and weights are assigned to securities based on their transformed carbon scores. Additional security, sector, and country constraints are applied.
  • SSGA Low-Carbon Framework (optimized): A mean-variance optimization is employed to either minimize tracking error at a target carbon-reduction level or to minimize carbon emissions at a target tracking error. SSGA opts for the latter, specifically minimizing carbon emissions at a tracking error of 75 basis points.

After testing these different portfolio types, SSGA recommends that investors use optimization when constructing a reduced-carbon portfolio, since “it best balances the multiple objectives investors have beyond just reducing carbon.” Tracking “error to the benchmark, which measures the amount of active risk investors” must “take on to reduce carbon, appears to be best managed using optimization.”

The money manager also found that over time, the optimized Low-Carbon Framework approach produced the greatest amount of carbon reduction. Plus, this same approach appears to produce the most stable level of carbon reduction per unit of tracking error. For investors who are concerned about risk, this indicates the best potential outcome.

SSGA also reviewed the active country exposures of the different strategies and found “that Iterative Tilting stood out with much more controlled active exposures. Sector exposures across the five portfolios were found to be” like “those of the country exposures.” However, the ETF issuer also noted that if investors just rotate “out of carbon-intensive sectors and overweighting low-carbon sectors,” that could lead to “significant tracking error.” So, SSGA suggests that deriving most “of the carbon reduction from security selection within sectors” could be a better approach for index investors.

Ultimately, SSGA “suggests that the tradeoff between carbon reduction and tracking error could be best managed using optimization,” since “investors can meet their carbon-reduction targets while also minimizing the amount of risk they (must) assume in deviating from their policy benchmarks.” Optimization is also more risk-efficient when contrasted with rules-based approaches.

State Street Global Advisors offers a series of ESG-focused ETFs, including the SPDR Kensho Clean Power ETF (CNRG), the SPDR MSCI Emerging Markets Fossil Fuel Reserves Free ETF (EEMX), the SPDR MSCI ACWI Low Carbon Target ETF (LOWC) (which is changing its name and ticker to the SPDR MSCI ACWI Climate Paris Aligned ETF (NZAC) effective Friday, April 22), and the SPDR MSCI EAFE Fossil Fuel Free ETF (EFAX).

For more news, information, and strategy, visit the ESG Channel.