Whatever the reasons for integrating environmental, social and governance (ESG) criteria in a portfolio, managing this exposure across multiple asset classes is significantly more complicated than managing it within a single asset class. 

The sustainability spectrum

The sustainability spectrum covers three levels of implementation:

• Screened – Negative screening beyond statutory requirements
• Integrated – ESG analysis is a building block of the investment process
• Sustainable – ESG analysis is a cornerstone of the investment process

There are advantages and disadvantages to each approach and the asset owner’s decision as to where to position their portfolio depends on factors such as

1. Which approach closest meets their beliefs regarding the importance of sustainable investing
2. The availability of investment assets managed using an ESG approach
3. The impact on the overall portfolio of different ESG approaches
4. The skill of the active managers in combining ESG into their processes
5. The timeframe over which a strategy will be evaluated
6. The cost of implementing an ESG strategy.

Regardless of which level of ESG engagement an investor pursues, we believe active (in preference to passive) management is more effective in its application for a variety of reasons. Importantly, active fund management can lessen unintended consequences, for example from excluding certain sectors, while ensuring that risk and return parameters are maintained, and more accurately assess companies’ ability to adapt to ESG challenges.

Introducing a sustainability budget

We believe that asset owners for whom ESG is an important theme should consider introducing a sustainability budget. This would be similar to the concept of the risk and governance budgets whereby sustainability features would be identified and implemented with a view to delivering better longer-term risk adjusted returns.

Having decided on the size of the sustainability budget, asset owners need to address two further, interlinked, points:

1)      The extent to which the sustainability budget impacts the risk and governance budgets

• Increasing the sustainability budget will increase the governance budget because more time and resources will be required to manage those assets in a sustainable way.
• Constraining the investment opportunity set – for whatever reason, sustainability grounds included - is likely to compromise the degree of diversification in the portfolio. As such, exposure to acute shorter-term risks resulting from unexpected shocks, may be higher for portfolios that take a sustainable approach to investing. If the asset owner’s time horizon is long enough, however, then such risks are of lesser importance. Indeed, the advantages of sustainable investing are expected to be realised mostly over the longer term.

2)      How the sustainability budget can be implemented

• This depends on the asset owners beliefs as to whether sustainability manifests itself through individual securities (in which case the budget should be implemented on a bottom-up basis) or whether it is more appropriate to do so at an asset allocation level

Consider ESG in light of whole portfolio

We believe that asset owners should consider ESG in the context of the entirety of their assets, rather than having a piecemeal approach to implementation through individual components. This requires decisions about where on the sustainability spectrum they should position their portfolios, as well as the introduction of a sustainability budget, to be managed alongside more traditional budgets such as governance and risk budgets. Evaluating the likely impact and trade-offs between the budgets will take time and discussion, but we believe that it is worthwhile to agree a position with regard to ESG for a whole asset portfolio.