Skip to content
Search

November 2023 / MULTI-ASSET

Integrating ESG Preferences in Asset Allocation

Optimizing with an added ESG risk constraint.

Key Insights

  • Incorporating ESG factors into our investment process alongside economic, valuation and other factors may help our clients to meet their long-term goals.1
  • We show how scores from our proprietary Responsible Investing Indicator Model (RIIM) may help to drive asset allocation in ESG-aware multi-asset portfolios.
  • Our framework allows us to adjust portfolio asset allocation in order to incorporate ESG preferences in a consistent manner.

We introduced an asset allocation framework for incorporating ESG preferences systematically in an earlier paper2. It used hypothetical examples to illustrate how to add a third dimension to the traditional two-dimensional efficient frontier of portfolio returns and risk, allowing investors to take into consideration their ESG risk tolerance - in addition to return and risk objectives - when constructing a multi-asset portfolio.

This paper is a natural extension to the first whereby the focus of the paper is on optimization around specific ESG pillars. We rely primarily on our proprietary Responsible Investing Indicator Model (RIIM), which develops an environmental, social and governance profile for corporate, sovereign, municipal and securitized securities using both qualitative and quantitative measures. It provides a systematic framework for measuring and comparing the ESG characteristics of over 15,000 corporate securities in addition to sovereign, securitized and municipal issuers. Because this model sets a common language for our investment professionals to evaluate ESG risks across asset classes, the ESG scores from RIIM can be used to help drive the asset allocation of ESG-aware portfolios, with the ability to focus on specific sustainability topics.

More specifically, RIIM produces scores for each of the three pillars of ESG – environmental, social and governance. Instead of utilizing aggregate ESG risk scores, we can focus on specific environmental, social, or governance aspects in building the overall score for each asset class. Disaggregating the ratings allows us to consider the elements within ESG that are the more relevant for each investor or strategy.

A consistent ESG scoring methodology across asset classes can be used to drive the asset allocation of ESG-aware portfolios.

Before delving into the details, it is worth noting that while RIIM is our preferred ESG risk rating framework, the same asset allocation approach works for other ESG scoring systems too. What is important is that ratings across asset classes should be based on a single source of ESG risk scores so that they can be compared consistently.

For illustration purposes, we have constructed a series of multi-asset portfolios that focus on environmental risks. The same approach can be applied to ESG social and governance risks as well.

For illustration purposes, we have constructed a series of multi-asset portfolios that focus on environmental risks.

Investment Assumptions and Constraints

Our starting point is a balanced portfolio consisting of 60% global equities and 40% global bonds. We then apply the following assumptions and constraints to the portfolio design:

  • The investment universe is comprised of major regional equity building blocks (i.e., the U.S., Europe, Japan, and Emerging Markets) and fixed income sectors (i.e., Global Aggregate, Global High Yield, and Emerging Markets Bonds) in order to construct a diversified global portfolio.
  • Return forecasts for different asset classes are based on our 5-year Capital Markets Assumptions (CMAs). Volatilities are constructed using historical return data over the past 5 years to reflect the most recent market environment (See Figures 1 and 2).
  • Environmental risk scores are aggregated scores of individual securities at the asset class level based on our RIIM. The higher the score is, the more environmental risk the asset class carries.
  • The allocation design of the initial portfolio is illustrated in Figure 3, in which regional equity allocations are based on country weights in the MSCI All Country World Index (ACWI) and fixed income sector allocations are based on the Global Multi-Asset team’s understanding of a typical global 60/40 balanced fund.
  • In the optimization analysis (Figure 4 on the next page), we set a 3.0% limit for the tracking error to the initial portfolio for two reasons: 1) it is an investment constraint common to institutional clients, so it mirrors real world experience; 2) it anchors the portfolio design to the benchmark thereby removing extreme solutions from the optimization process.
  • We set the constraint of a minimum single holding allocation of 3% and a maximum single holding allocation of 30% to ensure portfolio diversification and to avoid corner solutions.
  • We did not constrain the equity/fixed income mix in order to leave more room for the optimizer to find allocations with better risk-adjusted returns and mitigated environmental risk.

Assumptions For Portfolio Optimization With ESG Constraints

(Fig. 1)

Environmental risk scores, volatility and expected 5-year US dollar return assumptions are shown for the seven asset classes employed in the portfolio optimization.

The analysis in Figure 1 is based on the forecasts contained herein are for illustrative purposes only and are not indicative of future results.
Based on T. Rowe Price 5-Year Capital Markets Assumptions (CMAs) and RIIM Model. This study differs from the CMA in that it employs the S&P500 index in place of the Russell US Large Cap index to represent US equity and the ICE BofA Global HY Index in place of the Bloomberg Corp HY index to represent global high yield bonds.
In Figure 1 the size of each bubble is proportional to the volatility of each asset class.
As of June 30, 2023.
Sources: ICE BofA, J.P. Morgan, S&P, MSCI, Bloomberg Finance L.P. Analysis by T. Rowe Price. See Additional Disclosures for sourcing information.
This information is not intended to be investment advice or a recommendation to take any particular investment action. Forecasts are based on subjective estimates about market environments that may never occur. See the Appendix for Important Information on our capital market assumption and a representative list of indexes for the seven asset classes in Figure 1.
Expected returns are shown for asset classes without consideration of fees and expenses.

Asset Class Past 5-Year Monthly U.S. Dollar Return Correlations

(Fig. 2)

  U.S. Equity European Equity Japanese Equity EM Equity Global Aggregate Bond (Hedged) Global High Yield Bond EM Bond
U.S. Equity 1.00            
European Equity 0.88 1.00          
Japanese Equity 0.80 0.82 1.00        
EM Equity 0.73 0.79 0.74 1.00      
Global Aggregate Bond (Hedged) 0.44 0.41 0.41 0.42 1.00    
Global High Yield Bond 0.81 0.81 0.73 0.76 0.56 1.00  
EM Bond 0.61 0.68 0.60 0.76 0.60 0.89 1.00

As of June 30, 2023.
Sources: ICE BofA, J.P. Morgan, S&P, MSCI, Bloomberg Finance L.P. Analysis by T. Rowe Price. See Additional Disclosures for sourcing information. See Appendix for a representative list of indexes.

The Initial Portfolio

(Fig. 3)

The pie chart shows asset allocation weights for the initial 60/40 global balanced portfolio.

For illustrative purposes only (subject to change without further notice).
As of June 30, 2023.
Source: T. Rowe Price.
See Appendix for a representative list of indexes.

Optimization Results Summary For Environmental Risk-Constrained Portfolios

(Fig. 4) Returns are in U.S. dollars

Six pie charts summarise the optimization results for the environmental risk-constrained portfolios.
Portfolio Characteristics Initial Portfolio Portfolio 1 Portfolio 2 Portfolio 3 Portfolio 4 Portfolio 5 Portfolio 6
Expected 5-year Return (annualized) 7.6% 8.5% 8.4% 8.6% 8.4% 7.9% 8.0%
Expected 5-year Volatility (annualized) 12.0% 13.7% 13.5% 13.0% 11.0% 10.1% 10.0%
Return/Risk Ratio 0.63 0.62 0.63 0.67 0.76 0.79 0.79
Portfolio vs. Initial Portfolio Initial Portfolio Portfolio 1 Portfolio 2 Portfolio 3 Portfolio 4 Portfolio 5 Portfolio 6
Tracking Error 3.0% 3.0% 3.0% 3.0% 3.0% 3.0%
Excess Return 0.9% 0.8% 1.1% 0.8% 0.3% 0.4%
Information Ratio 0.30 0.28 0.35 0.28 0.11 0.12

As of June 30, 2023.
The forecasts contained herein are for illustrative purposes only and are not indicative of future results.
Based on T. Rowe Price 5-Year Capital Markets Assumptions (CMAs) and RIIM Model. Sources: ICE BofA, J.P. Morgan, S&P, MSCI, Bloomberg Finance L.P. Analysis by T. Rowe Price. See Additional Disclosures for sourcing information.
This information is not intended to be investment advice or a recommendation to take any particular investment action. Forecasts are based on subjective estimates about market environments that may never occur. See the Appendix for Important Information on our capital market assumption and a representative list of indexes for the seven asset classes.
Expected returns are shown for asset classes without consideration of fees and expenses.

Optimization Results

Figure 4 above summarizes the optimization results of asset allocation across a range of different environmental risk tolerance levels. Starting from Portfolio 6 – the portfolio with no consideration given to environmental risk and which hence has the highest environmental risk score, a standard mean-variance optimizer would assign a significant overweight to Emerging Markets Bonds and Global High Yield Bonds. The reasons behind this are two-fold: 1) The two asset classes have attractive risk-adjusted returns base on our 5-year CMAs; 2) These two credit asset classes have high correlations to equity assets and thus act as equity substitutes in the optimized portfolio.

As we decrease our tolerance for environmental risk moving toward the left-hand side of Figure 4, we observe reallocations from higher environmental risk assets, such as Emerging Markets Bond and Global High Yield Bond, to lower environmental risk assets like European and Japanese Equities. Interestingly, the allocation to U.S. Equity exposure, which has higher environmental risk than its developed market peers, starts to increase as we further reduce environmental risk tolerance. This is likely due to the optimizer’s attempt to use U.S. equity exposure to substitute for Emerging Markets Bond allocation to lower the overall environmental risk of the portfolio. The impact on the risk and return, however, does not follow a linear pattern.

A Comparison Between Global High Yield and Global Equity

(Fig. 5)

The chart compares the difference in industry/sector weights of global equity and global high yield with sector environmental risk scores.

As of June 30, 2023.
Source: ICE BofA, MSCI, Bloomberg Finance L.P. Analysis by T. Rowe Price. See Additional Disclosures for sourcing information.
Sector Environmental Scores are based on RIIM Model.
See Appendix for a representative list of indexes.

It turns out that this can be explained by their sector exposure differences to a large extent. As shown in Figure 5, compared to Global Equity, Global High Yield tends to overweight sectors with higher environmental risks, such as Consumer Discretionary and Energy, while underweighting sectors such as Information Technology and Health Care, which tend to be associated with lower environment risks.

Our framework allows us to adjust asset allocation and incorporate ESG preferences in a consistent manner.

Conclusion

In this simple illustrative exercise, we developed a framework to help investors adjust asset allocation and incorporate their ESG preferences in a consistent manner.

Appendix

T. Rowe Price Capital Market Assumptions:

The information presented herein is shown for illustrative, informational purposes only. Forecasts are based on subjective estimates about market environments that may never occur. This material does not reflect the actual returns of any portfolio/ strategy and is not indicative of future results. The historical returns used as a basis for this analysis are based on information gathered by T. Rowe Price and from third party sources and have not been independently verified. The asset classes referenced in our capital market assumptions are represented by broad-based indices, which have been selected because they are well known and are easily recognizable by investors. Indices have limitations due to materially different characteristics from an actual investment portfolio in terms of security holdings, sector weightings, volatility, and asset allocation. Therefore, returns and volatility of a portfolio may differ from those of the index. Management fees, transaction costs, taxes, and potential expenses are not considered and would reduce returns. Expected returns for each asset class can be conditional on economic scenarios; in the event a particular scenario comes to pass, actual returns could be significantly higher or lower than forecast.

Key Risks

Forecasts are based on subjective estimates about market environments that may never occur. Some of the factors that could impact these forecasts include, but are not limited to:

Political and economic conditions

Performance of financial markets

Interest rate levels

Changes to laws or regulations

Investments in equities are subject to the volatility inherent in equity investing, and their value may fluctuate more than investing in income-oriented securities. Certain asset classes are subject to sector concentration risk and are more susceptible to developments affecting those sectors than broader classes. Transactions in securities denominated in foreign currencies are subject to fluctuations in exchange rates, which may affect the value of an investment. Debt securities could suffer an adverse change in financial condition due to a ratings downgrade or default, which may affect the value of an investment. Investments in high yield involve a higher element of risk. Investments in less developed regions can be more volatile than other, more developed markets due to changes in market, political, and economic conditions. Investments are less liquid than those that trade on more established markets.

List of Representative Indices for Each Asset Class

The following indices represented each asset class in the empirical analysis in this paper:

U.S. Equity: S&P 500 Index

European Equity: MSCI Europe Index

Japanese Equity: MSCI Japan Index

EM Equity: MSCI Emerging Markets Index

Global Aggregate Bond (Hedged): Bloomberg Global Aggregate Bond Index USD Hedged

Global High Yield: ICE BofA Global High Yield Index

EM Bond: J.P. Morgan CEMBI Broad Diversified Composite Index

Global Equity: MSCI All Country World Index

Please note this study differs from the CMA in that it employs the S&P500 index in place of the Russell US Large Cap index to represent US equity and the ICE BofA Global HY Index in place of the Bloomberg Corp HY index to represent global high yield bonds.

Additional Disclosure

Bloomberg – “Bloomberg®” the Bloomberg Indices are service marks of Bloomberg Finance L.P. and its affiliates, including Bloomberg Index Services Limited (“BISL”), the administrator of the index (collectively, “Bloomberg”) and have been licensed for use for certain purposes by T. Rowe Price. Bloomberg is not affiliated with T. Rowe Price, and Bloomberg does not approve, endorse, review, or recommend these materials. Bloomberg does not guarantee the timeliness, accurateness, or completeness of any data or information relating to these materials.
MSCI – MSCI and its affiliates and third party sources and providers (collectively, “MSCI”) makes no express or implied warranties or representations and shall have no liability whatsoever with respect to any MSCI data contained herein. The MSCI data may not be further redistributed or used as a basis for other indices or any securities or financial products. This report is not approved, reviewed, or produced by MSCI. Historical MSCI data and analysis should not be taken as an indication or guarantee of any future performance analysis, forecast or prediction. None of the MSCI data is intended to constitute investment advice or a recommendation to make (or refrain from making) any kind of investment decision and may not be relied on as such.
S&P – The S&P500 is a product of S&P Dow Jones Indices LLC, a division of S&P Global, or its affiliates (“SPDJI”) and [Third Party Licensor], and has been licensed for use by T. Rowe Price. Standard & Poor’s® and S&P® are registered trademarks of Standard & Poor’s Financial Services LLC, a division of S&P Global (“S&P”); Dow Jones® is a registered trademark of Dow Jones Trademark Holdings LLC (“Dow Jones”); [Third Party Licensor Trademarks] are trademarks of the [Third Party Licensor] and these trademarks have been licensed for use by SPDJI and sublicensed for certain purposes by T. Rowe Price. [Licensee’s Product(s)] is not sponsored, endorsed, sold or promoted by SPDJI, Dow Jones, S&P, their respective affiliates, or [Third Party Licensor] and none of such parties make any representation regarding the advisability of investing in such product(s) nor do they have any liability for any errors, omissions, or interruptions of the [Index].
ICE BofA – ICE Data Indices, LLC (“ICE DATA”), is used with permission. ICE DATA, ITS AFFILIATES AND THEIR RESPECTIVE THIRD-PARTY SUPPLIERS DISCLAIM ANY AND ALL WARRANTIES AND REPRESENTATIONS, EXPRESS AND/OR IMPLIED, INCLUDING ANY WARRANTIES OF MERCHANTABILITY OR FITNESS FOR A PARTICULAR PURPOSE OR USE, INCLUDING THE INDICES, INDEX DATA AND ANY DATA INCLUDED IN, RELATED TO, OR DERIVED THEREFROM. NEITHER ICE DATA, ITS AFFILIATES NOR THEIR RESPECTIVE THIRD-PARTY SUPPLIERS SHALL BE SUBJECT TO ANY DAMAGES OR LIABILITY WITH RESPECT TO THE ADEQUACY, ACCURACY, TIMELINESS OR COMPLETENESS OF THE INDICES OR THE INDEX DATA OR ANY COMPONENT THEREOF, AND THE INDICES AND INDEX DATA AND ALL COMPONENTS THEREOF ARE PROVIDED ON AN “AS IS” BASIS AND YOUR USE IS AT YOUR OWN RISK. ICE DATA, ITS AFFILIATES AND THEIR RESPECTIVE THIRD-PARTY SUPPLIERS DO NOT SPONSOR, ENDORSE, OR RECOMMEND T. ROWE PRICE OR ANY OF ITS PRODUCTS OR SERVICES.
J.P. Morgan – Information has been obtained from sources believed to be reliable but J.P. Morgan does not warrant its completeness or accuracy. The index is used with permission. The Index may not be copied, used, or distributed without J.P. Morgan’s prior written approval. Copyright © 2023, J.P. Morgan Chase & Co. All rights reserved.

Important Information

This material is being furnished for general informational and/or marketing purposes only. The material does not constitute or undertake to give advice of any nature, including fiduciary investment advice, nor is it intended to serve as the primary basis for an investment decision. Prospective investors are recommended to seek independent legal, financial and tax advice before making any investment decision. T. Rowe Price group of companies including T. Rowe Price Associates, Inc. and/or its affiliates receive revenue from T. Rowe Price investment products and services. Past performance is not a reliable indicator of future performance. The value of an investment and any income from it can go down as well as up. Investors may get back less than the amount invested.

The material does not constitute a distribution, an offer, an invitation, a personal or general recommendation or solicitation to sell or buy any securities in any jurisdiction or to conduct any particular investment activity. The material has not been reviewed by any regulatory authority in any jurisdiction.

Information and opinions presented have been obtained or derived from sources believed to be reliable and current; however, we cannot guarantee the sources’ accuracy or completeness. There is no guarantee that any forecasts made will come to pass. The views contained herein are as of the date written and are subject to change without notice; these views may differ from those of other T. Rowe Price group companies and/or associates. Under no circumstances should the material, in whole or in part, be copied or redistributed without consent from T. Rowe Price.

The material is not intended for use by persons in jurisdictions which prohibit or restrict the distribution of the material and in certain countries the material is provided upon specific request. It is not intended for distribution to retail investors in any jurisdiction.

USA—Issued in the USA by T. Rowe Price Associates, Inc., 100 East Pratt Street, Baltimore, MD, 21202, which is regulated by the U.S. Securities and Exchange Commission. For Institutional Investors only.

© 2023 T. Rowe Price. All Rights Reserved. T. ROWE PRICE, INVEST WITH CONFIDENCE, and the Bighorn Sheep design are, collectively and/or apart, trademarks of T. Rowe Price Group, Inc.

Previous Article

November 2023 / FIXED INCOME

Perspectives on Securitized Credit
Next Article

December 2023 / VIDEO

Artificial Intelligence: The New Electricity?
202311-3222717