Biodiversity in the Balance: Revisiting Portfolio Risks

Key Insights:

• To illustrate how Morningstar Sustainalytics' material ESG issue (MEI) assessments could be integrated into a double materiality investment strategy that seeks to mitigate land use and biodiversity risks, three model portfolios were developed using a rule-based allocation method that could have been executed by investors with access to Sustainalytics ESG Risk Ratings during the study period between 2019 and 2023.

• In revisiting the portfolio performance since the report was published in January 2024, the three portfolios continued to perform well and the difference in their cumulative returns continued to expand. Since the start of the study period, the long-short portfolio delivered more than 122% cumulative return, compared to 97% for the lower MEI risk portfolio and 22.6% for the higher MEI risk portfolio.

• The higher MEI risk portfolio continued to be less volatile than the other two portfolios over our extended study period, with a standard deviation of 12.4%, compared to 13.6% for the lower MEI risk portfolio and 15.1% for the long-short portfolio; however, it also had a deeper maximum drawdown at 21.7%.

• These results suggest that the lower MEI risk and long-short portfolios could have provided some protection against downside financial risk.

Assessing Investment Exposure to Biodiversity Risks

As the 16th Conference of the Parties (COP 16) to the Convention on Biological Diversity (CBD) kicks off this week, the responsible investment community is refocusing its attention on the mounting challenges of biodiversity loss.¹ At the meeting in Colombia – one of the most biodiverse regions on Earth – participants from government, Indigenous communities, businesses and civil society groups will discuss a wide range of issues, including how to address habitat loss and protect endangered species.²

In an ESG Spotlight Series report that we published earlier this year, we assessed the impact of commercial activities on biodiversity in key markets. The report drew on data points that comprise parts of our ESG Risk Ratings.³ These data points also more recently became available through Morningstar Sustainalytics’ Nature Data Package.⁴

Among the findings of the report is our observation that a growing number of firms have been linked to land use and biodiversity controversies over the past decade. We attribute this finding to a combination of increased NGO reporting and improvements in our incidents tracking abilities. Since 2012, Sustainalytics has tracked more than 1,600 land use and biodiversity incidents that were associated with supply chain management and more than 770 that pertained to direct operational involvement. The food products industry accounts for most of these cases. Although relatively few incidents initially resulted in a high business impact and risk assessment, those that have tend to involve allegations of violations of Indigenous rights or destruction of endangered species’ habitat.⁵

While concerns about the social and ecological effects of biodiversity loss may be enough for some investors to integrate relevant environmental, social and governance (ESG) factors into their investment decision processes, many are increasingly focused on the idea of double materiality. Double materiality is an extension of the accounting concept of integrating material financial information in investment decisions to include assessments of an investment’s effects on the environment and society.

Comparing Three Model Public Equity Portfolios  

To illustrate how Sustainalytics’ material ESG issue (MEI) assessments could be integrated into a double materiality investment strategy that seeks to mitigate land use and biodiversity risks, we developed three model portfolios. Each portfolio uses a rule-based allocation method that could have been executed by investors with access to Sustainalytics ESG Risk Ratings during our study period between 2019 and 2023.

The stocks in all three portfolios were weighted according to their relative total market capitalization and rebalanced annually to account for changes in market capitalization, MEI risk scores and the expansion of our research universe coverage over time.⁶ Since this MEI is only applicable to a selection of industries, the sample consists mainly of companies in the consumer defensive⁷ and consumer cyclical⁸ sectors. As a result, the model portfolios are only representative of investment strategies in consumer goods companies, which are generally more exposed to this issue than most other sectors.

Over the initial study period, we found that the first model portfolio, which invests in stocks with lower MEI risk scores on Land Use and Biodiversity – Supply Chain, outperformed a second, higher MEI risk portfolio; the former delivered a cumulative return of 51.1%, compared to the higher MEI risk portfolio that had an 8.5% cumulative return. The outperformance of the lower MEI risk portfolio is mainly attributable to the effects of stock selection in consumer defensive and sector allocation effects in consumer cyclical.

Addressing the growing market interest in incorporating ESG signals into alternative investments, the third portfolio that we developed holds long positions in stocks with MEI risk scores below the sample median and short positions in stocks with MEI risk scores above the median. This strategy is long-biased, following the 130/30 allocation ratio that is popular among hedge funds because it allows fund managers to use leverage to improve capital efficiency, offering the potential of enhancing active returns.⁹ This long-short portfolio outperformed both the lower and higher MEI risk portfolios, yielding a cumulative return of 65.6%.

An Update on Our Three Model Portfolios

Since we published the report, the idea of developing ESG-driven alternative investment strategies has continued to gain momentum. In June, AQR Capital Management launched its Adaptive Equity Market Neutral UCITS Fund, which takes short positions in stocks that AQR views as having poor ESG profiles and long positions in stocks with better ESG performance. Other notable long-short equity funds that take ESG-driven long-short positions include Capital Fund Management’s CFM Quant Sustainable Absolute Return Fund and Trium Capital LLP’s Climate Impact Fund. However, according to data from Bloomberg, as of August 2024, this CFM fund was down about 4% since the beginning of the year, while the Trium fund was only up around 3%.¹⁰

For the occasion of COP 16, we extended the timeframe of our portfolio analysis from the beginning of 2019 to the end of Q3 2024. As shown in Figure 1 below, the three portfolios continued to perform well and the difference in their cumulative returns continued to expand. Since the start of the study period, the long-short portfolio delivered more than 122% cumulative return, compared to 97% for the lower MEI risk portfolio and 22.6% for the higher MEI risk portfolio.

Figure 1. Cumulative Returns of Three Model Portfolios Based on Land Use and Biodiversity – Supply Chain Risk Scores

_{Source: Morningstar Sustainalytics. For informational purposes only.
Note: Study period is from Jan. 1, 2019 to Sept. 30, 2024. Initial study period to Oct. 31, 2023.}

The higher MEI risk portfolio continued to be less volatile than the other two portfolios over our extended study period, with a standard deviation of 12.4%, compared to 13.6% for the lower MEI risk portfolio and 15.1% for the long-short portfolio; however, it also had a deeper maximum drawdown at  21.7%. These results suggest that the lower MEI risk and long-short portfolios could have provided some protection against downside financial risk.

Figure 2. Measuring the Performance and Risk of Three Model Portfolios (%)

_{Source: Morningstar Sustainalytics. For informational purposes only.
Notes: Portfolios built using the Land Use and Biodiversity – Supply Chain MEI. Study period is from Jan. 1, 2019 to Sept. 30, 2023.}

Conclusion 

As we emphasized in the report, determining whether factors specifically connected to land use and biodiversity contributed to the differentials in the returns of these portfolios and their constituent stocks is beyond the scope of this study; these results may be due to overlapping correlations among multiple variables, such as a quality factor tilt, rather than a causal relationship between this MEI and stock performance. However, this analysis and the financial metrics that we explored can serve as a starting point for assessing what companies with strong performance are doing to address ESG issues. In the report, we go into more detail about specific companies that contribute most to the relative performance of each portfolio. We also identify other areas of research that investors can look at when developing strategies that aim to improve portfolio performance while mitigating risks related to land use and biodiversity.

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References

1. United Nations Biodiversity Conference, 2024. Sixteenth meeting of the Conference of the Parties to the Convention on Biological Diversity (COP 16). https://www.cbd.int/conferences/2024.
2. The Nature Conservancy, 2024. COP16: What’s at stake for the 2024 UN Biodiversity Conference. https://www.nature.org/en-us/what-we-do/our-priorities/protect-water-and-land/land-and-water-stories/biodiversity-global-conference/.
3. Morningstar Sustainalytics, 2024. ESG Data. https://www.sustainalytics.com/esg-data.
4. Morningstar Sustainalytics, 2024. Nature Data Brochure. https://www.sustainalytics.com.
5. Vezér, M., & Sang, Q. 2024. “Biodiversity in the Balance.” Morningstar Sustainalytics. Jan. 2024. https://connect.sustainalytics.com/biodiversity-in-the-balance-esg-spotlight.
6. For companies with incomplete historical market cap data, prior year’s data is used. For example, if there is no market cap data after 2021, then 2021’s data is carried over to 2022 and 2023.
7. Companies engaged in the manufacturing of food, beverages, household and personal products, packaging, or tobacco. This sector also includes companies that provide services such as education and training services.
8. This sector includes retail stores, auto and auto parts manufacturers, companies engaged in residential construction, lodging facilities, restaurants, and entertainment companies.
9. Johnson, G., Ericson, S., & Srimurthy, V. 2007. “An Empirical Analysis of 130/30 Strategies: Domestic and International 130/30 Strategies Add Value Over Long-Only Strategies.” The Journal of Alternative Investments. http://www-stat.wharton.upenn.edu/~steele/Courses/434/434Context/StructuredProducts/Empirical130-30Strategies.pdf
10. Pham, L. 2024. “AQR Gets $350 Million for Fund Pitching Long-Short ESG Bets.” Bloomberg. Aug. 2024. https://www.bloomberg.com/news/articles/2024-08-22/aqr-attracts-350-million-for-fund-pitching-long-short-esg-bets.