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• In June 2018 we launched a Zero Carbon Portfolio for a university endowment fund
• The objective was to deliver the performance of a global equity index whilst fully excluding companies with exposure to fossil fuels and positively including Socially Responsible Investments
• In addition to a successful back-test, the live portfolio has delivered on objectives

What is Zero Carbon investing
The Zero Carbon Society at Cambridge University is one of many campaign groups calling for university endowment funds to divest from all fossil fuels.  This has been termed “Zero Carbon” investing.
The divestment trend started in the US in 2012 when the city of Seattle divested from fossil fuels.  In 2014, Stanford University followed suit.  Campaigns across the US and UK led to other universities following suit.  Some of the reasons universities found it hard to ensure that their investments were “fossil free” is because:

• Collectives: Use of collective investment schemes meant it was hard to pressure fund houses to change investment style, on something that would affect all clients
• Alternatives: Use of hedge funds and alternative strategies meant it was hard to vouch for full exclusion on a look-through basis
• Trackers: Use of low-cost tracker funds meant indirect exposure to energy stocks
• Definitional uncertainty: if you invest in a FTSE 100 future does that create “exposure”?
• Opportunity Set: Concern about a narrowing of the investment opportunity set
• Methodology: low carbon and ESG funds could nonetheless include energy companies with strong green credentials and substantial investment in renewable energy

The challenge
When set this challenge by a university college, we proposed to do two things.  Firstly to create a Zero Carbon SRI benchmark to show how Zero Carbon investing could be done whilst also focusing on other ESG considerations.  Secondly, to create a Zero Carbon portfolio to deliver on the primary aim of full divestment.
 
Creating a Zero Carbon SRI benchmark
We wanted to create a benchmark for the endowment’s managers that not only screened out fossil fuels, but went further to screen out one of the main consumer of fossil fuels, the Utilities sector, as well as other extractive industries – namely the Materials sector.  We also wanted to screen in companies with high ESG scores and low controversy risk and cover the global equity opportunity set.  We worked with MSCI to create a custom index, the catchily-named (for taxonomy reasons) the MSCI ACWI ex Energy ex Materials ex Utilities SRI Index (the “Custom Index”, please refer to Notice below).

Creating a Zero Carbon portfolio
The second part of the project was to create an implementable investment strategy that maintained a similar risk-return profile to World Equities, but fully excluded the Energy, Materials and Utilities sectors.  Rather than creating a fund which introduces additional layer of costs, this was achievable using sector-based ETF portfolio.

This portfolio meets the primary objective of creating a Zero Carbon, fully divested, world equity mandate.  In the absence of ESG/SRI sector-based ETFs, it is not yet possible to create a sector-adjusted ESG/SRI ETF portfolio.  But we expact that to change in the future.

Custom Index Performance
The back-test of both the custom index could deliver similar risk-return characteristics to global equities.  The concern was would those back-test results continue once the index and portfolio went live.  The answer is yes.  Whilst the custom index has shown outperformance, that was not the objective.  The objective was to access the same opportunity set, but with the fossil-free, ESG and socially responsible screens in place.

Fig.1. Custom Index performance simulation from June 2012 & live performance from June 2018

Zero Carbon Portfolio performance
Similarly, the Zero Carbon portfolio has delivered comparable performance to MSCI World – hence no “missing out” on the opportunity set whilst being fully divested from fossil fuels.  Although not intentional, the exclusion of Energy, Materials & Utilities has benefitted performance and meant that the performance, net of trading and ongoing ETF costs, is ahead of the MSCI World Index.

Fig.2. Zero Carbon ETF portfolio performance from June 2018

Summary
Whatever your views on the pros and cons of divestment, Zero Carbon investing is not an insurmountable challenge, and the combination of index solutions and ETF portfolios solutions creates a range of implementable options for asset owners and asset managers alike.

IMPORTANT NOTICE ABOUT THE CUSTOM INDEX
With reference to the MSCI ACWI ex Energy ex Materials ex Utilities SRI Index (“Custom Index”). Where Source: MSCI is noted, the following notice applies.
Source: MSCI.  The MSCI data is comprised of a custom index calculated by MSCI, and as requested by, Queens’ College Cambridge.  The MSCI data is for internal use only and may not be redistributed or used in connection with creating or offering any securities, financial products or indices.  Neither MSCI nor any third party involved in or relating to compiling, computing or creating the MSCI data (the “MSCI Parties”) makes any express or implied warranties or representations with respect to such data (or the results to be obtained by the use thereof), and the MSCI Parties hereby expressly disclaim all warranties of originality, accuracy, completeness, merchantability or fitness for a particular purpose with respect to such data.  Without limiting any of the foregoing, in no event shall any of the MSCI Parties have any liability for any direct, indirect, special, punitive, consequential or any other damages (including lost profits) even if notified of the possibility of such damages.

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Summary

• Indices codify a criteria-based approach to ESG investing
• Index methodology means screen, score and weight each company
• ESG indices enable similar performance, but with ESG compliance

 
Defining terms
With a growing range of ethical investment propositions available to portfolio designers, we first of all need to define and disambiguate some terms.

• Ethical investing: this is an established investment approach that considers investors’ social and moral preferences, and typically relied on exclusions (typically excluding companies with exposure to “vice” – for example armaments, gambling or alcohol).  Traditionally the approach of religious charities, this approach is becoming mainstream.
• Environmental, Social and Governance (“ESG”): the index provider, MSCI, rates companies based on their approach to Environmental issues (such as Climate change, Natural resources, Pollution & waste and Environmental opportunities); Social issues (such as approach to Human capital, Product liability, Stakeholder opposition and Social opportunities); and Governance issues (such as Corporate governance and Corporate behaviour)[1].
• Socially Responsible Investing (“SRI”): using MSCI’s definitions, this approach incorporates ESG ratings as for ESG, but goes one step further to exclude companies whose products have negative social or environmental impacts; removing companies involved in Thermal Coal mining and power generation; and exclude companies involved in controversies.

​Criteria-based approach works well for indices
Applying ESG criteria to a universe of equities acts as a filter to ensure that only investors are only exposed to companies that are compatible with an ESG investment approach.
Creating a criteria-based approach requires a combination of screening, scoring and weighting.
Looking at the MSCI World SRI 5% Capped Index, for example, means:

1. Screening: removing companies with exposure to Nuclear Power, Tobacco, Alcohol, Gambling, Military Weapons, Civilian Firearms, GMOs, Thermal Coal and Adult Entertainment.
2. Scoring: means only including companies that score above a certain level on their MSCI ESG Rating and MSCI Controversies score.
3. Weighting: to make sure the final index has similar risk-return exposure to the parent index (so as not to impact portfolio construction parameters such as risk, return and correlation); index methodology can target similar sector and region weights as the parent index.  Furthermore to ensure that, as a result of all this screening and scoring and weighting adjustments, single-stock exposure (which creates systematic risk) does not become too concentrated, a 5% cap restricts the allocation to any single stock.

 
Indices codify criteria
An index is “just” a weighting scheme based on a set of criteria.  A common, simple index is to include, for example, the 100 largest companies for a particular stock market.  SRI indices reflect weighting schemes, albeit more complex, but importantly, represent a systematic (rules-based) and hence objective approach.  However, the appropriateness of those indices is as only as good as their methodology and the quality of the screening, scoring and weighting criteria applied.

Proof of the pudding
To mix metaphors, the proof of the pudding is in the making of performance that is consistent with the parent index, whilst reflecting all the relevant scoring and screening criteria.  This allows investors to have their ESG cake, as well as eating its risk-return characteristics.
Contrast, for example, the MSCI World Index with the MSCI World Socially Responsible Investment 5% Issuer Capped Index.  The application of the screening and scoring reduces the number of companies included in the index from 1,601 to 386.  But the weightings adjustments are such that the relative risk-return characteristics are similar: the SRI version of the parent index has a Beta of 0.98 to the parent index and is 99.4% correlated with the parent index.
 
Fig.1. Comparative long-term performance

Source: Bloomberg data,
​Focus on compliance, not hope of outperformance
Indeed pressure on the oil price and the performance of technology this year (technology firms typically have strong ESG policies) means that SRI indices have slightly outperformed parent indices.
However, our view is that ESG investing should not be backing a belief that performance should or will be better than a mainstream index.  In our view, ESG investing should aim to deliver similar risk-return characteristics to the mainstream index for a given exposure but with the peace of mind that the appropriate screening and scoring has been systematically and regularly applied.

​[1] For more on this ratings methodology, see https://www.msci.com/esg-ratings