Climate Investing

8Enhancing Environment-driven Portfolios with Traditional Factors

This chapter investigates the efficacy of combining traditional factors with environmental data when building optimal equity portfolios. Our contribution departs from the traditional literature by focusing on allocations designed to adjust benchmark policies. We allow compositions to be embedded in a general factor framework in which firm characteristics are the main drivers of the portfolio weights. Our results suggest that it is feasible to improve the environmental score of a portfolio without it being too detrimental to its out-of-sample performance. However, pure sustainable attributes alone do not allow us to fulfill this objective: they need to be enhanced by non-ESG predictors to deliver their full potential.

8.1. Introduction

Investors are increasingly concerned about the environmental footprint of their equity portfolios. Consequently, their demand for “green” assets is surging exponentially and studies on the relationship between sustainability and performance have blossomed (see Coqueret (2021) for equities and Flammer (2021) for bonds). This has led money managers to include new objectives and indicators when composing their allocations, and the most widespread criteria are the so-called environment, social and governance pillars.

Investors willing to allocate according to environmental considerations (or ESG criteria more generally) face a plethora of integration methods, which we split in two, ...