Author Details

Padmakar Kulkarni

Padmakar Kulkarni
Executive Director, MSCI Research

Chirag Gosar

Chirag Gosar
Vice President, MSCI Research

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Building Climate-Aware Factor Portfolios

  • Factor investors may want to make their investment process more climate-aware but often ask what the impact of this evolution may be on their strategy’s characteristics.
  • An optimization-based bottom-up approach resulted in an index that achieved the multiple objectives of factor exposure, investability and improved climate profile, and can serve as a basis or benchmark for factor portfolios.
  • In our study sample, we found it was possible to create single- and multi-factor indexes that retained their core objective of high target-factor exposures while also being aligned with the low-carbon transition and the Paris Agreement.

Factor investing typically involves both security selection and alternative weighting based on security-level factor exposure. If such a strategy also needs to be climate-aware, what is the cost in terms of target-factor erosion? Our earlier research showed how an optimization-based bottom-up approach to index construction facilitated ESG integration into factor investing without significant impacts on historical performance and factor characteristics. We now expand this approach to include climate-based outcomes in alignment with the Paris Agreement,  including the risks and opportunities associated with the transition to a lower-carbon economy, the physical risks associated with climate change and net-zero corporate targets.1

Our analysis studied the behavior of five simulated single-factor indexes for the value, low-volatility, quality, yield and momentum factors, and a simulated multi-factor index based on the MSCI World Index using an optimization-based approach. Factors were represented by the style-factor exposures defined in the MSCI Global Total Market Equity Model for Long-Term investors.

The climate-based outcomes are defined by the MSCI Climate Paris Aligned Indexes (PAI) methodology and include decarbonization relative to the cap-weighted opportunity set; year-on-year self-decarbonization at 10% per year; an uplift to weights for companies with green revenues or net-zero targets; and a reduction in Climate Value-at-Risk and physical climate risk.
We simulated two versions for each factor index from Nov. 29, 2013, to March 31, 2021. Version one was an optimized factor index (referred to as “Opt factor x” in our exhibits) that seeks to maximize exposure to the target factor, subject to tracking error and other investability constraints. Version two was version one combined with the climate-based outcome constraints (referred to as “factor x PAI”).
 

Value Showed the Greatest Erosion, Low Volatility the Least

Among the version two indexes, the value-factor index exhibited more target-factor erosion than the others, while the low-volatility-factor index was the least impacted. The results for the quality, momentum and multi-factor indexes fell between value and low volatility, while the analysis for the yield factor showed results similar to those of value.

For value, active exposures to the target factors, book-to-price and earnings yield, shrunk by almost 30% when the climate-based constraints were added. Similarly, the average price-to-earnings ratio for the Value PAI (at 13x) was one point higher than it was for Opt Value.
 

Impact of Climate-Based Outcomes on the Value Factor


WACI stands for weighted average carbon intensity (t CO2e/$M sales).

On the other hand, for low volatility, active exposure to the Beta factor in the Min Vol PAI was -0.80 vs. -0.87 for Opt Min Vol, while historical total risk for Min Vol PAI was 10.2% vs. 10% for Opt Min Vol. 

Impact of Climate-Based Outcomes on the Low Volatility Factor

Opt Min Vol was simulated using the MSCI Minimum Volatility Indexes methodology.

Hence, it was possible to add climate-based outcomes to the optimized factor indexes without significant erosion in active exposures to the target factors during our study period. The exhibit below shows the climate metrics for the simulated factor PAI indexes, as well as those observed in the MSCI World Climate Paris Aligned Index and the market-cap-weighted MSCI World Index, as of March 31, 2021.

 

Climate Metrics for the Simulated Factor Paris Aligned Indexes

 

Climate-Aware Factor Portfolios

While the MSCI Climate Paris Aligned Indexes framework used for this analysis is a multi-pillar approach, some factor investors looking to align their strategies with the path to net-zero emissions may opt to only add specific climate-based outcomes, such as year-on-year self-decarbonization, instead of all the climate-based outcomes included in the PAI methodology.
 
Our analysis suggests that one could have combined factors and the PAI framework in single- and multi-factor indexes that retained their core objective of high target-factor exposures while being able to align with the path to net-zero emissions and the Paris Agreement. Such approaches can be used to benchmark and as the basis for climate-aware factor portfolios. 
 

1Indexes can be considered eligible for the Paris-Aligned benchmark designation as detailed in “Commission Delegated Regulation of 17.7.2020.” European Commission, July 17, 2020. 

Further Reading

Aligning with the Paris Agreement: An Index Approach

Aligning Portfolios with the Paris Agreement

The MSCI Factor ESG Target Indexes

Integrating ESG criteria into factor index construction

Factor and ESG: the truth behind three myths

Are Factors & ESG the New Tea & Biscuits?

Factor Strategies with ESG Integration

Regulation