Mind the Gap: Efficiently Replacing Sustainability Exclusions

Abstract

Sustainable investors tend to exclude the least sustainable companies from their portfolios. The gap created by these underweights is commonly filled by naïvely rescaling the remaining stocks in proportion to their market capitalizations. However, we find that much better results can be obtained with more sophisticated portfolio management techniques. One alternative is to minimize the tracking error of the portfolio. Another is to take the forced underweights as an opportunity to improve the expected return, by selecting stocks with attractive factor characteristics as replacements. Our empirical tests validate the substantial performance boost from both methodologies.

Keywords: Sustainable investing, carbon footprint, SDG, Sustainable Development Goals, factor investing, quant investing, risk management, portfolio management, ESG

JEL Classification: G11, G12, G14