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Minimum variance and sustainable investments: a harmonious relationship

To ensure that sustainability does not come at the expense of return, investors need to improve the risk-return-efficiency of their portfolios. Risk-based strategies such as minimum variance are very well suited for this. They allow integrating strict sustainability restrictions without compromising performance.

Pecunia non olet – money does not stink [1] – is a well-known Latin saying. Can this also be said of returns? Therefore, if money does not stink, must the same apply to the return? In the context of sustainable investment, this would require that the market is always able to separate the wheat from the chaff – sustainable from unsustainable companies. One prerequisite for this is that the risks of environmentally damaging or unsocial company practices are correctly priced by the market. If all external effects are included in the price of an investment, the return has already been corrected for the sustainability effect. As a logical consequence, investors would not have to deal with the issue of sustainability and could leave it to the market. However: Are the market incentives strong enough and clear enough for listed companies worldwide to strive for virtuous behaviour?

Does the market create incentives for virtuous behaviour?

The classic financial market theory is based on the hypothesis of an (information) efficient market which is able to immediately incorporate all relevant information about a company into its stock price. Companies whose behaviour is unsustainable would thus be classified as riskier by the market: they would have to make more effort to finance themselves on the market and would be penalised with a lower valuation. That alone would be incentive enough to comply as much as possible with sustainability principles.

So what is the market exactly? It is in fact an impersonal entity which reflects only the average of all investors. However, investors are not always rational – even on average. Their behaviour is often short-sighted and driven by greed and fear.

The self-regulation function of the market is therefore questioned by supporters of behavioral finance. They doubt whether one can actually price in sustainable behaviour in a globalised financial market, especially since, as will be described in the following paragraph, there are no globally valid sustainability standards.

Not everyone understands sustainability in the same way

What does sustainable investing really mean? Despite everyone talking about it, sustainability cannot be defined by objective and universal principles. To stake out the topic one speaks today of ESG representing the three areas environment, social and governance. In their interpretation the zeitgeist along with diverse cultural, social and geographic sensibilities, play a crucial role. From slavery to child labour to pollution: practices that were once considered normal are – fortunately – no longer tolerated today. For example, smoking: Remember the legendary television debates, where gesticulating guests were barely recognisable through the cigarette smoke – from today’s perspective unthinkable! Historically, there have been very big differences in the perception and acceptance of ESG criteria and these differences are still strong today. A survey of friends about the definition of sustainability and priorities in the application of ESG principles will produce different answers. Personal values are shaped by social and societal sensibility. What is especially striking are the differences between regions, continents and cultures, which in turn influence how urgently a certain sustainability criterion is being called for from various groups of investors.

Private investors can determine their ideas regarding sustainability and its implementation in an individual investment strategy and consciously accept the costs or opportunity costs. This is immeasurably more complicated for institutional investors who, like insurance companies or pension funds, manage funds for a large number of beneficiaries on a fiduciary basis. They face several problems (at once): What is the common denominator of investors regarding ESG criteria? How restrictive should their application be and upon which ESG definition should the criteria be based? Does an ESG committee have to be called? How detailed should the ESG investment process be in the rules and regulations? How to define governance and control processes? In addition, a further question which, in view of the lower return expectation, is utterly existential: how does the consideration of ESG criteria influence performance?

Sustainability and the return issue

So far there has been no scientifically conclusive answer as to whether and how the inclusion of ESG criteria has a positive or negative effect on returns. In the last 20 years, several studies have been published, sometimes with very different results, not least because of the underlying data, methodology used and definition of ESG criteria. Simply put, two groups can be distinguished: The first one expects the integration of ESG to have a negative effect on returns. This view is supported by empirical analyses which show that sin stocks regularly outperform the market. These include companies which behave in compliance with the law, but operate in less sustainable and responsible business areas such as alcohol, tobacco, gambling and weapons. The Sin Stocks Report [2] also includes companies which attract negative attention through very aggressive sales practice – for example, in the allocation of consumer credit – or by exploitative working conditions.

The other group believes that companies guided by higher ESG standards also have better risk control, which has a long-term positive impact on returns.

According to Cliff Asness, founder of the asset management company AQR and widely recognized professional also in scientific circles, the inclusion of ESG cannot lead to a higher return because, compared to an investment process without restrictions, the investment universe is limited. Sustainable investing therefore contradicts the goal of achieving the highest possible return, or in other words: “virtue is not a free lunch” [3]. Investors who ban certain securities from the portfolio due to ESG restrictions push their price down. Underpricing induced by selling pressure increases the expected return for investors who are not concerned about ESG. This assessment is confirmed in the long-term outperformance of sin stocks. This empirical evidence seems to confirm that there is a price to pay by including ESG – a loss in return.

Is there sinful excess return?

Even though companies known as sin stocks do not cover or violate all ESG categories, their performance has been the subject of numerous scientific studies. They thus represent the longest and best-analysed data series to evaluate the implications and opportunity costs of investing sustainably in a portfolio.

A study which goes back the furthest is one which includes US equity data from the 1920s onwards. The results are unambiguous: regardless of whether aggregated or broken down into individual sins, immoral investments consistently outperform the market index [4].

A similar conclusion is reached in an extensive study by Fabozzi, Ma and Oliphant, which takes into account the performance of sin stocks from 21 countries [5]. Between 1970 and 2007, both the aggregate international sin portfolio and individual sin country portfolios clearly outperformed the market capitalised index.

In a meta-study, Dimson, Marsh and Staunton [6] identify the factors behind the above average returns of sin stocks: they can count on stable demand for their products and services, operate internationally and boast a high margin. In addition, they are shielded from competition thanks to a high market entry threshold. As soon as a majority of investors avoid these stocks for ethical reasons, this can create a buying opportunity for investors who are not concerned about ESG criteria.

Our own analysis in Figure 1 (based on the MSCI ESG database [7]) shows the performance of each MSCI ESG rating category – from AAA as the highest rating to CCC as the lowest rating – for the MSCI Equities World Index over the last ten years. The chart shows that an investment in equities from the worst and best rating categories promises an above-average return. Accordingly, a passive, market cap weighted approach to the exclusion of equities with CCC ratings would result in lower portfolio return. A difficult starting position for institutional investors with a passive investment strategy who have to integrate ESG criteria into their investment process but cannot accept performance losses!

Factor analysis provides clarity and leads to a solution

So why are sin stocks doing better? A differentiated analysis of the influence of individual factors on the equity price provides the answer – and a solution to the dilemma.

The latest findings come from a study by Fabozzi and Blitz [8] published in autumn 2017. In 2008, Fabozzi identified the excess return of sin stocks (see previous section), and now in this study the two authors drill down to their factor properties. From similar analyses, it has already been established that the sin stocks outperformance persists even when the classic factor contributions such as value, size and momentum are neutralised. Fabozzi and Blitz supplement this evaluation with three factors: low volatility, profitability and investments. Similar to the 2008 study, they use global data over 50 years and also differentiate their outcomes by region.

The result is astonishing: the outperformance of sin stocks can be fully explained by the three additional factors for almost all equity regions. Profitability and investments in particular seem to have a major impact, with profitability and low volatility (as well as minimum variance [9]) having very similar characteristics. This finally clarifies an anomaly that has been empirically proven for decades but not yet explained. Sin stocks are not more profitable because they ignore sustainability. Instead, the route cause is to be found in the deeper characteristics of these securities: sin stocks show, on average, a lower operational and financial risk, meaning on average more stable cash flow, higher profitability and lower level of debt than the market average. These very same characteristics are also found in low volatility and quality stocks.

“Sin stocks are not more profitable because they ignore sustainability, but because of their deeper characteristics.”

This is good news for sustainability-conscious investors: as a result, potential return losses in an ESG portfolio can be offset by a higher weighting of ESG-compliant companies which have exactly those characteristics, or can be classified as low volatility or quality securities.

Figure 2 shows the historical performance of the Vice Fund [10] – a well-known sin stock fund – compared to the OLZ Equity World Optimized ESG strategy and the MSCI World Index. The performance comparison shows a distinct excess return in the sin stocks compared to the MSCI World Index. It is interesting, however, that our minimum variance strategy has a comparable return considering ESG criteria. And thanks to smaller fluctuations (risk), even better performance (Sharpe Ratio) than the Vice Fund.

For this to succeed, investors must abandon traditional indexing. This applies in particular to institutional investors who have hitherto used the market cap index both as a benchmark and as a – demonstrably suboptimal – investment portfolio.

Based on the market-cap index as an investment portfolio, institutional investors do not generate lower return because they invest sustainably but because they neglect portfolio efficiency. Instead of holding a cap-weighted ESG-portfolio, it is advisable to invest in an investment portfolio that has, for example, the properties of “low volatility” or “quality” and is structured more efficiently.

High affinity between ESG and minimum variance

Similar characteristics as identified by Fabozzi and Blitz in the analysis of sin stocks are also found in risk-based strategies such as the OLZ minimum variance investment approach: lower risk goes hand in hand with higher profitability, stable cash flow and lower level of debt [11].

We tested what influence the exclusion of sin stocks and the consideration of ESG criteria according to the MSCI ESG database has on the performance for all OLZ strategies. The results confirmed our expectation: performance (risk-return profile) is not significantly altered by the inclusion of ESG restrictions. A sufficiently large universe of securities ensures that the exclusion of sin stocks, or of securities generally with unfavourable ESG criteria, does not overly restrict the degrees of freedom of our risk-based minimum variance models and thus has no impact on performance. Figure 3 illustrates this observation with a comparison of the perfor-mance of the OLZ Equity World portfolio with and without ESG restrictions.

“Institutional investors do not generate lower return because they invest sustainably but because they neglect portfolio efficiency.”

MSCI study: Trade-off between factor intensity and ESGA study by MSCI (2016) comes to a similar conclusion. It confirms that minimum variance and ESG can be combined very well [12]. The study compares several portfolios, each representing a specific factor strategy: value, size, dividend yield, momentum, quality and minimum volatility (minimum variance). For each of these strategies, the extent to which increasing the ESG score affects factor intensity is measured. Figure 4 shows how the factor exposure of each strategy changes with a gradual increase of the ESG value. The lowest influence is found in the risk-based minimum variance strategy and the quality factor, where profitability plays a central role. The value and size approaches are diluted the most by ESG.

The excellent compatibility of ESG and risk-based strategies was empirically proven by MSCI for 2016 for Swiss equity funds. The OLZ minimum variance strategy achieved the top quartile of the ranking and this before ESG criteria were even considered in the investment process.

Conclusion: Sustainable investment is possible without loss of returns

A growing number of investors are no longer prepared to accept what is true today: pecunia olet – returns stink – because the market is unable to match ESG requirements with the spirit of the times. But this is increasingly demanded by institutional investors such as insurance companies or pension funds, who manage assets on a fiduciary basis. To ensure that sustainability does not sacrifice returns, investors have to improve the efficiency of their portfolios. The discussion about sustainability and the introduction of ESG into the investment process should be used to scrutinise the existing investment approach and focus on the portfolio’s efficiency.

There is potential for improvement, in particular for passive investors who use the market-cap index both as a benchmark and as an investment strategy [13]. Only by changing the investment process to an appropriate factor strategy can they meet the demands of their clients regarding the sustainability of their investments without sacrificing returns.

In this respect, risk-based investment strategies such as minimum variance have the advantage over other factor approaches such as value, size or momentum. They enable efficient allocation of the risk budget and allow strict ESG restrictions to be met without compromising returns.

Pecunia non olet: A clean return without loss is possible. But only if the investment process is holistically optimised and trimmed to maximum efficiency.


[1] The phrase is attributed to Emperor Vespasian in response to criticism of the tannery tax which he set up on the use of urine collected (for leather tanning) from public toilet.

[2] www.sinstocksreport.com

[3] C. Asness; Virtue is its own Reward: or, one man’s ceiling is another man’s floor; AQR May 2016

[4] H. Hong, M. Kacperczyk; The price of sin: the effects of social norms on markets; Journal of Financial Economics 2009

[5] F. Fabozzi, K. Ma, B. Oliphant; Sin stocks return; Journal of Portfolio Management 2008

[6] E. Dimson, P. Marsh, M. Staunton; Responsible investing: does it pay to be bad? Credit Suisse Yearbook 2015

[7] MSCI ESG is one of the leading providers of ESG information, analyses and evaluations. MSCI ESG takes into account more than 8000 issuers, who are rated by around 150 analysts using consistent methodology.

[8] F. Fabozzi, D. Blitz; Sin stocks revisited: resolving the Sin Stock anomaly; Journal of Portfolio Management; Fall 2017

[9] The minimum variance investment approach is based on the optimised composition of low volatility stocks taking into account correlations with the aim of minimising portfolio risk.

[10] The Vice Fund is managed by USA Mutuals Advisors Inc. Fund under US law. Investments are global with an overweight in the US.

[11] OLZ Research Note (Januar 2017)

[12] D. Melas, Z. Nagy, P. Kulkarni; Factor investing and ESG integration; MSCI Research Insight November 2016

[13] Current market practice is characterised by the trend to replicate the market cap index. While such a strategy may seem convenient and practical, financial market research leaves no doubt that it is sub-optimal from a risk-return perspective. For equity investments, a selected combination of factors such as low volatility, quality, etc. leads to more efficient portfolios.


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