Ahead of the Qontigo Summit, Olivier d’Assier analyzes the cost of adapting a portfolio to meet global warming targets using a STOXX Paris-Aligned Benchmark Index. The results show that an early but gradual transition can dramatically reduce the market impact and transaction costs.
If you didn’t get the memo, climate change is here, and it will get worse before it gets really, really bad. And that’s the good scenario! President Elect Joe Biden during his campaign called climate change “the existential threat to humanity” and vowed to immediately rejoin the Paris Accord once elected. His win increases the probability that regulatory voices will soon be added to popular demand for climate impact investing. And if you thought the consequences for delaying a transition to a low carbon emission economy were bad for the environment, delaying your transition to climate investing could be even worse for your portfolio.
Our research simulates the transition path from a cap-weighted benchmark to a Paris Accord Climate-compliant one, using the STOXX® USA 900 parent index and its Paris-Aligned Benchmark (PAB) variant1. The first thing to keep in mind about these new climate indices is that their goal is to facilitate a transition towards low carbon emission investing. Their starting point is a set of constituents that represent a 50% reduction in current emission levels from the parent benchmark, but then call for an ongoing 7% year-on-year improvement in the decarbonization rate of its constituents. The implication for investors is that the 2.5% tracking error that the initial PAB construction had in June 20202 with its cap-weighted parent index is only going to get bigger with time, never smaller.
Using their respective constituents as of September 30, 2020, transitioning from the parent index to the PAB variant would require a two-way turnover of 69%. If that sounds big, consider that it will only get bigger with time and that this trade list will become increasingly crowded, generating increasing (market) impact from (climate) impact – impulsum e impulsum.
In our upcoming paper3, we simulate this rebalancing using three different trading strategies. First, an orderly transition, limiting trades as a percent of average daily volume (ADV) for each stock, to ‘hide’ our decarbonization move. We varied the ADV constraint from 1% to 5% and used a range of portfolio size from USD 100 million to USD 5 billion. We find that as of September 30, 2020, even for large portfolios with AUM of up to USD 5 billion, this transition can be fully executed even with tight trading constraints.
Next, we conducted the same analysis but instead of the ADV constraint, we used a constraint not to generate more than 10 bps of aggregate market impact to execute the transition (i.e. we do not want to move the market against us – more expensive buys, cheaper sells – by more than 10bps). We also wanted to know if this was still possible to achieve if more than one manager had the same idea, at the same time – no portfolio is an island.
In this simulation we varied the size of the portfolios we traded with this strategy from USD 100 million to USD 200 billion4. If only USD 5 billion tries to squeeze through the market on a single day, a respectable 74% of this trade list can be executed for that level of market impact. The completion rate falls to just 20% if USD 200 billion try to transition on the same day, making the virtual trading counter look like the checkout counter at Macy’s on Black Friday with traders trampling over each other to buy and sell the same stocks!
In our third simulation, we wanted to quantify the aggregate market impact that would have occurred if regulation was put in place that ‘forced’ all portfolio managers to transition to the PAB on September 30, 2020. In other words, how much would it cost all investors in terms of market impact to execute 100% of the trade list in a single day? We again varied the size of the trade list from USD 100 million to USD 200 billion. A USD 5 billion trade list would lose over USD 7.5 million to market impact. A USD 200 billion trade list would lose over USD 1.3 billion!
The other variable affecting market impact other than the size of the trades, is volatility. On September 30, 2020, the predicted volatility of the STOXX USA 9003 was ‘only’ 21%. We repeated the simulation with an analysis date of June 22, 2020 when the predicted market volatility was 32%. In this higher volatility regime, the market impact cost of the USD 5 billion trade list rises just 7.6% to USD 8.1 million, but by a whopping 58.6% to USD 2.1 billion for the USD 200 billion trade list – impulsum e impulsum e impulsum…
So, without further gilding the lily, if you’re serious about climate impact investing and want to transition to a PAB index, do it now, but do it slowly – fast decision and slow trades will get you safely across the decarbonization gap. Remember, an early transition saves the planet and saves your portfolio – salutis e salutis.
Olivier will be presenting his findings at the Qontigo Investment Intelligence Summit on 9 December. Register now.
1 We ran the same analysis on the STOXX® Europe 600 and the STOXX® Global 1800 and their PAB variants. Read our whitepaper, “An Introduction to the STOXX Paris-Aligned Benchmark Indices” to learn more.
2 As of our analysis date of September 30, 2020, the tracking error is still 2.5%.
3 Title: “Climate Impact Investing Is Coming On Fast… What Portfolio Managers Need to Know – and Do – to Successfully Make the Transition”
4 As of our analysis date of September 30, 2020, the tracking error is still 2.5%.
