The five practical issues of incorporating ESG into multi-asset portfolios
Establishing an ESG philosophy at a total portfolio level
While it is possible to put together a portfolio of individual ESG components, our view is that asset owners should select these to be consistent with their ESG philosophy and consider ESG for asset allocation. There are many definitions of ESG and components could have very different characteristics. For example, a screened equity portfolio could remove all exposure to oil and gas companies whereas an integrated equity portfolio may retain companies that were demonstrating a commitment to adopt a strategy in line with the globally agreed Paris goals on carbon reduction.
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.
The effect on the total portfolio of using ESG asset components or removing asset classes that cannot incorporate ESG
Building a multi-asset portfolio that meets the sustainability budget set by the asset owner depends in large part on the availability of sustainable components. Where components are not available for all of the asset classes in the asset owner’s strategic asset allocation, a compromise will have to be made between the extent of diversification and sustainability in the portfolio.
In the most basic terms, portfolio risk is made up of two components: the risk of the individual components (standalone risk), and the relationship between the components (diversification benefit). The former will always have a positive contribution to risk, while the latter will reduce risk.
Removing asset classes can be expensive in terms of risk as this approach tends to increase total portfolio risk and concentration risk in the remaining asset classes, thus illustrating the importance of the availability of asset class components to a sustainable multi-asset portfolio. If an asset owner is on a journey towards a 100% sustainability budget, removing components to achieve this aim will compromise diversification in the portfolio.
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.
The application of ESG to asset allocation decisions
There are two main types of asset allocation that most asset owners consider. Strategic asset allocation is typically set over multiple economic cycles, perhaps 10-30 years. Over this time period we would expect sustainability to impact the return/risk and correlation assumptions used. It therefore seems reasonable that for asset owners who take sustainability issues seriously, the strategic asset allocation should incorporate ESG.
For dynamic asset allocation, the situation is more nuanced. Decisions to over- or underweight asset classes are typically taken on a shorter term (3-12 month) time horizon. ESG factors rarely have an impact over this time horizon, or if they do, are likely to be included in the valuation factor. For this reason, we do not think that ESG should play a material part in short-term market calls.
However, there may be medium-term “core active” positions, such as regional equity or bond allocations. At this stage, the evidence about the impact of ESG factors over this time horizon is less clear than for longer horizons.
The application of ESG to component asset classes
We define three different levels of ESG implementation along a spectrum of sustainability:
- Screened – Negative screening beyond statutory requirements
- Integrated – ESG analysis is a building block of the investment process. It is systematic and there is a commitment to engagement and stewardship
- Sustainable – ESG analysis is a cornerstone of the investment The resulting portfolio has a strong sustainability profile, focused on generating returns that can truly be maintained over the long term.
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.
Impact evaluation of ESG consistently across the portfolio
Once the ESG components have been identified, asset owners should aim to understand both the extent of the ESG decisions they have made in their overall portfolio and the quality of the sustainability, particularly the total impact of being sustainable. The latter is complex and requires a consistent methodology to evaluate the benefit to the overall portfolio of taking a sustainable approach.
Any security(s) mentioned above is for illustrative purpose only, not a recommendation to invest or divest.
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