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Source, Flickr. User 401(K) 2012

One of the most significant barriers to the mainstreaming of sustainable investment is the belief that sustainability underperforms. Choosing companies through an environmental, social and governance (ESG) lens, the belief goes, is a doomed practice, destined to put a drag on portfolio returns.

It is true that many asset managers have taken steps to integrate ESG data into the way they manage their portfolios, but the vast majority of the world’s $60 trillion in assets under management is not subject to this type of analysis.   

The mainstream’s skepticism about ESG is understandable. On a theoretical level, it is not always obvious that a good ESG performer would be a good portfolio performer. And even for those investors that are keen to explore ESG investment strategies, there are other, more practical challenges. For instance, ESG data has only been around for about a decade – a pittance in an industry that spans more than 140 years.

While this doesn’t mean that ESG analysis isn’t valuable, or that companies with good ESG performance cannot be good financial bets, it does mean that investors can’t conduct the kind of long-term financial backtests that they’re accustomed to building to evaluate new investment theses.

Another challenge is that many of the third-party vehicles that investors have historically used to integrate ESG into their portfolio decision making, including ESG ratings, are often “black boxes” – that is, they’re difficult for outsiders to break down, test and understand.  

To help investors overcome some of these barriers, Corporate Knights Capital built a new application that we call Sustainable Beta – what we believe to be the world’s first interactive sustainable portfolio construction tool. It’s not a panacea, we know, but it can help demystify sustainable investment strategies and, perhaps most importantly, it can transparently show how ESG data can be used to boost – not harm – portfolio performance.

(To test-drive Sustainable Beta, go to corporateknightscapital.com, select “Our Services” and then go to “Portfolios.”)

Users of Sustainable Beta are invited to build their own equity portfolios using five different inputs. First, select your market. Options include Australia, Canada, Europe, Japan and the United States. Next, select the specific ESG factor you would like to test. Five factors can currently be tested: Board Diversity, Carbon, Energy, Water and Tax.

Once these two fundamental decisions are made, you then decide how the portfolio should be normalized (e.g., how the ESG factor should be measured), how it should be weighted (e.g., by market capitalization or equal weight) and how often you would like it to be rebalanced (annually, semi-annually, quarterly or monthly).

After selecting all of the inputs and generating a portfolio, you can see how the portfolio would have performed against the major benchmark in your selected market (e.g., S&P 500 in the United States) from as far back as January 2008 up to the end of June 2014. 

The tool typically builds portfolios by scanning all companies that are available in the chosen market and selecting those that perform favourably on the chosen factor.  

Many of the portfolios that can be built on Sustainable Beta fail to beat their benchmark. For instance, an annually rebalanced market capitalization-weighted portfolio of Canadian carbon leaders (normalized by sales) would have underperformed the S&P/TSX Composite by 9.9 per cent from January 2010 to June 2014.  

But some portfolio permutations significantly outperform their benchmarks. For instance, an annually rebalanced, equally weighted portfolio of U.S. carbon leaders (normalized by number of employees) would have outperformed the S&P 500 by an astonishing 41 per cent from January 2008 to June 2014.

More analysis would be needed to properly attribute this outperformance – the weight scheme, for example, is sometimes a more significant determinant than the sustainability factor – but these and other results certainly call into question the orthodoxy that sustainable investing is doomed to underperform.  

Sustainable Beta is unique because of its transparency and flexibility. We are not aware of any other publicly available portfolio construction tool that lets users explore such a wide range of sustainable investment strategies. If it can play some role in the mainstreaming of ESG investing, it will have been a success.

We encourage you to give it a try.

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