Reducing the Carbon Intensity of Low Volatility Portfolios

Abstract

In recent years, interest has heightened in ESG, particularly regarding the integration of climate risk metrics such as carbon intensity in institutional portfolios. This article focuses on low volatility equity strategies, which are a natural candidate for examining the impact of incorporating climate risk as both forms of investing focus on risk. The authors find that meaningful levels of carbon reduction can be achieved across a range of low-volatility-type portfolios without compromising the volatility reduction objectives of the portfolio. There is also a point at which further reducing carbon has an increasingly negative impact on volatility reduction. Based on the authors’ historical simulations, between 30% and 70% is the range in which this tipping point occurs.

TOPICS: ESG investing, portfolio theory, portfolio construction

Key Findings

• • We find that meaningful levels of carbon reduction can be achieved across a range of low-volatility-type portfolios without compromising the volatility reduction objectives of the portfolio.

• • The pathway to a lower carbon footprint is highly dependent on managing the utilities sector exposure. Minimum variance portfolios are effective in exploiting both sector allocation and stock selection effects to form a portfolio that simultaneously meets low volatility and carbon objectives.

• • There is also a point at which further reducing carbon has an increasingly negative impact on volatility reduction. Based on our historical simulations, between 30% and 70% is the range in which this tipping point occurs.