The five practical issues of incorporating ESG into multi-asset portfolios

In our last paper - Managing sustainability from a total portfolio perspective - we established how asset owners can include a sustainability budget alongside their risk and governance budgets. How to implement this at a total portfolio level is the next challenge that asset owners face.

We believe that there are five practical issues asset owners need to address when implementing environmental, social and governance (ESG) considerations across assets:

1. Establish an overarching ESG philosophy that applies across the total portfolio

We believe that ESG factors should be taken into account to make better investment decisions. The primary impact of ESG factors is in security selection, but we also believe it is important to consider ESG for asset allocation.

When constructing a total asset portfolio, asset owners can position their assets on a spectrum from unsustainable (0%) to 100% sustainable investing. Positioning on this spectrum may require a trade-off between sustainability and diversification; an asset owner may choose to have a lower sustainability budget that includes some non-sustainable components in order to improve diversification and reduce risk. This trade-off should form part of the asset owner’s ESG philosophy.

We believe it is important to understand the aggregate impact of investment choices rather than a piecemeal approach using different metrics.

2. Understand the effect on the total portfolio of using ESG asset components or removing asset classes that cannot incorporate ESG

Removing non-ESG components can be expensive in terms of risk because such an approach tends to increase total portfolio risk and concentration risk in the remaining asset classes, while decreasing the diversification benefit.

By contrast, our research suggests that replacing a non-ESG component with an ESG component can improve diversification and is ‘low-cost’ in terms of risk. It therefore seems sensible to substitute sustainable components into the portfolio, where available because this approach doesn’t tend to compromise an asset owner’s risk, return of sustainability objectives.

3. Decide whether ESG should be applied to asset allocation decisions, and if so, how

Asset allocation decisions can be categorised as either strategic (i.e. longer-term, 10-30 years) or dynamic (i.e shorter-term, 3- 12 month time horizon). For asset owners aiming for 100% sustainability in their assets, the strategic asset allocation should incorporate ESG. For dynamic asset allocation, the relevance of ESG to the decision depends on the time horizon of the view. Extra ESG insights are more likely to influence the medium term than the short term.

4. Decide how ESG will be applied to the component asset classes 

ESG can be applied across asset classes, from developed and emerging market equities to sovereign and corporate bonds as well as insurance-linked securities, with varying degrees of complexity. In aggregate, and where possible though, we believe that the component should be managed with a sustainable approach as this seeks to identify truly long-term businesses.

5. Figure out how to evaluate the impact of ESG consistently across the portfolio

The total impact of a multi-asset portfolio’s investments is the most important (though the hardest to measure!), to ensure it is making the best use of its sustainability budget. We have encountered numerous issues in doing so, so this is a work in progress for us (and the subject of a future paper). However, we strongly believe that it is important to have a consistent methodology across asset classes and to be able to report using an ESG ‘dashboard’.

In this paper we consider all of these issues, providing our views and approach to help asset owners with the same dilemmas we have faced when developing ESG multi-asset portfolios.