Scientific Beta warns on using low carbon strategies as a source of alpha
In a new research paper, In a new research paper, When Greenness is Mistaken for Alpha: Pitfalls in Constructing Low Carbon Equity Portfolios , Scientific Beta highlights the danger of using low carbon strategies as a source of superior performance.
Press Release - Boston, London, Nice, Paris, Singapore, Tokyo, June 7, 2021
Scientific Beta warns on using low carbon strategies as a source of alpha
The use of a false source of alpha such as the low carbon factor has negative consequences on the risk-adjusted performance of portfolios
In a new research paper, In a new research paper, When Greenness is Mistaken for Alpha: Pitfalls in Constructing Low Carbon Equity Portfolios, Scientific Beta highlights the danger of using low carbon strategies as a source of superior performance.
The authors of the study find that, contrary to what is often affirmed by promoters of low carbon strategies, the low carbon factor is not a rewarded factor. In actual fact, a serious analysis of the performance of the low carbon factor decreases it from 1.74% to -0.32% once exposures to the traditional rewarded equity factors are accounted for.
Mistakenly using low carbon strategies as a source of alpha actually reduces portfolio performance for investors who have access to standard equity factors. Constructing portfolios using low carbon scores like any other alpha score does not improve performance and leads to problems with concentration and investability.
The costs borne by investors who build portfolios with a mistaken belief in a positive low carbon alpha are substantial. Multi-factor portfolios that impose positive weights on the low carbon factor have an inferior risk-return profile: A low carbon allocation of 40% leads to a poorly factor-diversified portfolio and as a direct consequence gives up 100bp of annualised returns on a risk-adjusted basis.
Finally, the study also shows that the use of carbon scores, in an approach that is termed “integrated,” because it mixes these scores with scores on the traditional equity styles at stock level, does not improve portfolio performance.
The results suggest that using low carbon strategies as a source of alpha is costly to investors. This does not imply that investors cannot benefit from low carbon investing. Investors should analyse whether low carbon strategies can help them hedge climate risks or make a positive impact on corporate behaviour.
Commenting on these findings, Dr Noël Amenc, CEO of Scientific Beta, said, "Investors need to reconsider how to design low carbon strategies in order to maximise their impact. The pressing issue faced by society is tackling climate change, not generating alpha. And while low carbon alpha appears to be fake, the damage from climate change unfortunately is real."
The Scientific Beta white paper can be accessed through the link below:
About Scientific Beta:
Scientific Beta aims to be the first provider of a smart factor and ESG/climate index platform to help investors understand and invest in advanced factor and ESG/climate equity strategies. Established by EDHEC-Risk Institute, one of the top academic institutions in the field of fundamental and applied research for the investment industry, Scientific Beta shares the same concern for scientific rigour and veracity, which it applies to all the services that it offers investors and asset managers. On January 31, 2020, Singapore Exchange (SGX) acquired a majority stake in Scientific Beta. SGX is maintaining the strong collaboration with EDHEC Business School, and principles of independent, empirical-based academic research, that have benefited Scientific Beta's development to date. Since 2015, Scientific Beta has also been offering highly advanced strategies in the area of ESG and climate change, whether involving options integrated into smart beta indices or pure ESG or climate benchmarks. As a complement to its own research, Scientific Beta supports an important research initiative developed by EDHEC on ESG and climate investing and cooperates with V.E and ISS ESG for the construction of its ESG and climate indices.
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