As this chart shows, tracking error varies significantly over time in response to the market environment, notably during 2022 and 2023.
For the MSCI World Climate Change Index, the rolling 12-month average tracking error varied between about 100 basis points and 400 basis points over the five-year period. In some cases, we see tracking error increasing for one index while decreasing for another, as in 2023 when the climate change index diverges farther from the parent index while the selection index tracks more closely. Interpreting the causes of these swings is complicated by the intricate and interwoven nature of the sustainability criteria in each methodology. Nevertheless, our analysis makes clear that sustainable passive methodologies carry volatile and diverse implied tracking-error profiles that introduce risks to a portfolio.
The first of these is performance risk, as seen when sustainability-related tilts and biases led to underperformance in adverse market conditions, such as the energy supply shocks and higher inflation and interest rates in 2022-2023. This risk is often linked to the time horizon implied by a strategy’s sustainability convictions. Themes such as climate transition that play out over a prolonged period lean on longer-term sources of excess returns, and these may not always coincide with short- and medium-term performance drivers. Without a mechanism for reducing volatility, passive sustainable strategies may face challenges from cyclical and shorter-term market dynamics.
The second important consideration is the need to account for transparency and control risks. Most sustainable indices involve a combination of intricate and correlated sustainability parameters. The complexity of these parameters and their interactions may obscure the impact they have on the risk and return profile of investment strategies designed to track these indices. We believe that without a clear understanding of how sustainability criteria influence portfolio composition and performance, it will ultimately be difficult to actively manage the associated risks.
A strategy for addressing sustainability-related risks in passive equity strategies needs to accomplish three key tasks:
- Systematically manage the risks introduced by sustainability criteria
- Smooth out performance volatility
- Provide transparency in the attribution of impact on performance
We think an Alpha Enhanced approach can help investors achieve these goals. These strategies are designed to create the potential for outperformance through investments that deviate from a benchmark while keeping risk within acceptable limits. An investment manager capable of implementing alpha views with a low correlation to a strategy’s sustainability-related tilts can most efficiently manage the risks that arise from sustainability criteria, in our view. The added alpha component can smooth out a strategy’s return profile by reducing the impact of sustainability-related tilts, thereby smoothing out short-term volatility and boosting resilience to cyclical market moves.
In analyzing performance, it can be challenging to separate the impacts from sustainability criteria and alpha views because the two components are intertwined. For this reason, we think a quantitative approach capable of sequencing the implementation of sustainability criteria and the alpha-engine overlay is needed. The first step is to minimize the tracking error introduced by sustainability criteria, dampening the impact of the resultant tilts and biases. The next step is to maximize the resultant risk-adjusted portfolio performance by incorporating a systematic alpha engine designed to operate within a tracking-error budget determined by the client.
This sequenced approach balances the two sources of active risk – the implementation of sustainability criteria and the addition of the alpha engine – in a way that can produce a more resilient sustainable equity solution, in our view. Integrating an alpha engine is intended to efficiently address performance risk, helping smooth out the performance impacts of sustainability criteria. Since passive sustainability approaches tend to be reliant on the idiosyncratic performance patterns resulting from sustainability parameters, a moderate alpha component can allow investors to incorporate more systematic sources of excess return, potentially balancing out the portfolio’s overall return profile.
By incorporating alpha views uncorrelated with sustainability criteria, this approach yields potential diversification benefits in the use of risk budgets, because some of the sustainability-related risk can be used for alpha generation. As a result, the total tracking error of the two-step process is lower than the tracking error each step would incur independently – a more efficient use of tracking error that can improve the risk-adjusted return profile of the portfolio, This approach could also contribute to cost efficiency by optimizing the active risk allocation and offering the potential for moderate excess returns that are not offered in typical passive index replication approaches.
Importantly, the fact that each step is done separately allows for a clear distinction between excess returns and tracking error originating from systematic bottom-up stock selection, versus the bespoke sustainability criteria. We view this transparency as a very powerful tool for investors to have more decision-useful data about how their sustainability objectives influence their portfolio’s risks and returns, which could in turn help investors better assess how they will evolve their sustainability parameters, keeping performance in mind.
Source: am.gs.com
