Exclusion-based investment strategies can quickly spin out of control as the proportion of banished stocks rises above 2 per cent of the index, according to a new Russell Investments research paper.
The ‘Negative screening and performance consequences: how much is too much?’ study found return expectations on a global shares portfolio quickly destablise as exclusion levels hit between 2-5 per cent of the benchmark (the MSCI World Index in the case of the Russell analysis).
Both the spread of expected returns and monthly volatility (as measured by tracking error) in the Russell study steadily ratcheted-up as the proportion of stock exclusions rose from 2 to 5 per cent of the index.
However, rebalancing post-exclusion portfolios by sector rather than via “naïve” whole-of-index techniques can “buy” investors some flexibility to dump more stocks without material damage to expected risk-and-return ranges – but only up to a limit, the Russell paper says.
“As we move into 5% exclusions and higher (which might be similar to tobacco plus controversial weapons plus relative carbon footprint for an index) we find that simple sector neutrality is no longer sufficient to manage the widening of the excess return distribution,” the study says.
The report says as the popularity of portfolios based on environmental, social and governance (ESG) criteria increases, investors need to understand more clearly how those exclusion decisions impact risk and return parameters.
Negative screening effects are likely more profound for active investors, the study says. For example, passive global equities funds may be able to exclude tobacco stocks (equivalent to about 1 per cent of the index) without harming expected returns.
“… for actively managed portfolios, even a tobacco exclusion may represent a higher percentage of the investable universe,” the paper says. “… In these cases, the ability to manage unintended exposures becomes more critical when accommodating investor-preferred exclusions.”
The analysis – carried out by Russell investment strategy research director, Leola Ross, and analyst, Miao Ouyang – covers 20 years of MSCI return and tracking error data from 1997, split into two 10-year periods. Instead of a traditional back-tested return method, the Russell study ran 6,000 performance simulations based on portfolios where randomised stock exclusions ranged over 1-5 per cent of the index.
Ross and Ouyang repeated the process for both ‘naïve’ and sector-specific post-exclusion rebalancing techniques while also comparing tracking error distributions across all samples.
“This exercise quantifies our intuition and puts some sensible limits on just how much a portfolio can be restricted,” the study concludes. “These results are extremely useful to help investors to assess what exclusions mean and their potential impact.”