Portfolio Optimization for Index Tracking with Constraints on Downside Risk and Carbon Footprint

TL;DR

This paper develops decarbonized indices for index tracking that incorporate downside risk and carbon footprint constraints, balancing financial performance with environmental impact.

Contribution

It introduces two methodologies for constructing decarbonized indices that optimize downside risk measures like VaR and ES while reducing carbon footprints.

Findings

Decarbonized indices effectively track market indices with lower downside risk.

The methodologies demonstrate improved risk-adjusted returns compared to traditional indices.

Transparency in index construction encourages firms to lower carbon emissions.

Abstract

Historically, financial risk management has mostly addressed risk factors that arise from the financial environment. Climate risks present a novel and significant challenge for companies and financial markets. Investors aiming for avoidance of firms with high carbon footprints require suitable risk measures and portfolio management strategies. This paper presents the construction of decarbonized indices for tracking the S \& P-500 index of the U.S. stock market, as well as the Indian index NIFTY-50, employing two distinct methodologies and study their performances. These decarbonized indices optimize the portfolio weights by minimizing the mean-VaR and mean-ES and seek to reduce the risk of significant financial losses while still pursuing decarbonization goals. Investors can thereby find a balance between financial performance and environmental responsibilities. Ensuring transparency in the development of these indices will encourage the excluded and under-weighted asset companies to lower their carbon footprints through appropriate action plans. For long-term passive investors, these indices may present a more favourable option than green stocks.