Sustainability criteria such as ESG criteria are too important to be ignored in investment decision making, research by Allianz Global Investors suggests.
A new report from risklab, AllianzGI's specialist investment and risk advisor, said environmental, social and governance (ESG) risk optimised investment strategies can improve portfolio efficiency significantly.
As ESG factors are an important source of investment risk, they should be part of the investment research to minimize extreme risk, it added.
Steffen Hörter at risklab said: "In today's capital markets investors are increasingly diversifying away from low yielding government bonds into growth assets, such as emerging market equities and corporate bonds, to achieve their investment aims. Our research shows that ESG risk factors can impact the extreme risk of these asset classes significantly."
The study found the tail risk of an ESG risk neutral emerging market equity strategy defined by the MSCI Emerging Markets Index can be reduced from -64.5 p.a. to -38.8%. The same is true for corporate bonds defined by the Merrill Lynch Global Broad Market Corporate Index, it added, where the tail risk - measured as conditional value at risk (95%) of the default strategy - can be reduced from -8.1% p.a. to -4.9%.
ESG risk factors are also important for core asset classes such as developed market equity, the report said. The research shows a tail risk optimisation potential of the ESG neutral default strategy defined by the MSCI World Equity Index from -38.1% p.a. to -25.7%. The results are amplified for strategies where the ESG risk profile is negatively leveraged versus the default, ESG neutral strategy defined by the benchmark.
Hörter added: "Our research demonstrates that ESG risk optimised investment strategies can improve portfolio efficiency. Portfolios should be analysed, for example, for exposure to carbon risk, energy risk, or social and corporate governance risk. All these risks are an important source of investment and risk optimisation."
Research published by Mercer earlier this year warned pension funds should factor in climate change risk to their asset allocation strategies over the next two decades or face losing trillions of pounds. (Global Pensions: 15 February 2011)
The consultant said climate change policy will account for 10% of a pension fund's portfolio risk by 2030, with costs hitting about £5trn by 2030.
It added funds could combat the growing policy risk headache by diversifying their portfolios away from equities and bonds into "climate sensitive" assets such as infrastructure, real estate, private equity, agriculture land, timberland and sustainable assets.
Mercer forecasts a portfolio trying for a 7% return could cancel out the climate change risk by allocating 40% of its funds to these assets.
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