ESG integrated Portfolio construction and management Flashcards
MVO Mean-variance optimization
minimum standard deviation
link to ESG issues:
model is highly sensitive to baseline assumptions
highly dependent on historical data
volatility as a proxy for risk does not work well in cases of fat tails risk and large market swings
outputs to reflect ESG issues: ESG issues could impact on assumptions regarding exp(r), volatility, and correlation at the asset and sub-asset class level.
-also have the potential to expand the regional and asset class mix and to add new sub-asset classes to align with the pursuit of positive real-world impact
Factor risk allocation
ERP
link to ESG issues:
the macroecnomic links to ESG issues are more difficult to quantify with precision from a purely top-down perspective.
Market risk factors can be built from the bottom-up using asset and sector level analysis
outputs to reflect ESG issues:
ESG issues could require a change to baseline factor risk assumptions.
Offer the potential to build in new ESG-related risk factors to improve diversification.
Total portfolio analysis TPA
SIMILAR TO factor risk model, but closer review between strategy setting process and alignment of investment goal.
link to ESG issues:
TPA is relevant to consider ESG issues that require the interplay between judgement about the future and quantitative analysis.
Require specialist knowledge to make informed judgments about future risk
outputs to reflect ESG issues:
TPA’s emphasis on risk budgeting and allocation of capital to opportunities within that budget would provide greater flexibility to capture the potential winners and losers in scenario analysis that also incorporate ESG-related issues
Dynamic asset allocation DAA
driven by changes in risk tolerance, typically induced by cumulative performance relative to investment goals or an approaching investment horizon.
link to ESG issues:
DAA could introduce an additional source of estimation errors due to the need for dynamic rebalancing.
outputs to reflect ESG issues:
DAA has the potential to reflect changes in baseline assumptions over different time horizons.
Liability driven asset allocation
LDI seeks to find the most efficient asset class mix driven by a fund’s liabilities.
potential link to ESG issues:
LDI encounters the same limitations as MVO, with high sensitivity to baseline assumptions
outputs to reflect ESG issues:
Some ESG issues could potentially impact on inflation and alter liability assumptions
Regime switching models
it abrupt and persistent changes in financial variables due to shifts in regulations, policies and other secular changes.
Captures fat tails, skewness and time-varying correlations.
potential link to ESG issues:
regime switching approaches are relevant for considering ESG issues where an abrupt shift is expected over time. It is also typically based more on forward looking rather than historical data.
outputs to reflect ESG issues:
These approaches have the potential to capture dramatic shifts in the investment environment.
Models are not yet widely utilized by investment practitioners.
most promising approaches maybe the BLM black-litterman asset allocation model
anchored by the global equilibrium market and not requiring return estimates for each asset class, it can argueably better accommodate areas like pricing climaite risk.
portfolio risk can be divided into two portfolios:
- the isolated risk of the individual asset or individual investment strategy
- the correlation risk that emerges from the combination of all the assets and strategies
trade-offs with allocating the risk budget to sustainability-aligned assets and strategies
no ESG components - 0% sustainable
ESG components that can be managed sustainably
+ non-esg components for those that cannot be managed sustainably <100% sustainable but fully diversified
ESG components that can be managed sustainably
+remove components that cannot currently be fully sustainable - approaching 100% sustainable but reduced diversification
All ESG components - 100% sustainable
climate change/risk has emerged as the most material ESG factor for institutional investors to address within asset allocation strategies
both systemic and local
macro-economic climate consideration by asset class
Equities
SAA/ALM Implications
- hedge against inflation which can result from supply shock and high government spending
- sensitive to growth, macro-economic performance
climate change consideration
- sensitive to climate impacts on macro-economic perforance
Fixed income
SAA/ALM implication
- sensitive to interest rates
- typically less volatile returns
climate change consideration
- sensitive to fiscal policy related to climate challenges
- sensitive to climate- related impacts on issuers’ creditworthiness
- many climate impacts fall within the tenor of long-term debt
Alternative investment
SAA/ALM implication
- attractive for diversification and for low or inverse correlation to market returns
- heterogeneous and wide-ranging risk/return profiles
climate change consideration
- diversification offered by alternative assets may allow for greater hedging of climate risk
- climate risk exposure may be concentrated, opaque or difficult to assess
Task Force on Climate-related Financial Disclosures TCFD framework
climate scenario analysis is as important in the wider asset allocation process as it is in understanding the micro, macro and ESG sensitivities within a single investment portfolio.
the asset allocator would work to sensitize the portfolio against different warming scenarios using the 1.5c as promoted in the paris agreement 2015 as a baseline.
physical risks
represent the physical risks manifested by climate change that may impact businesses’ operations, strategy, infrastructure, workforce or markets.
Transition risk
risks represented by legal, regulatory, policy, technology and market change in the transition to a low carbon economy.
driving both national and corporate commitments towards Paris-aligned net zero carbon emission targets
with regard to forward-looking data to describe the shape of the transition - is leading to an improved understanding for portfolio management analysis.
Paris Aligned Investment Initiative PAII
is a European asset owner-coordinated and led initiative working to develop methodologies and assessment tools related to aligning investment portfolios to Paris Agreement.
Transition Pathway Initiative TPI
is a global, asset-owner driven, asset-manager supported initiative developed in partnership with the Grantham Research Institute on Climate Change and the Environment at the London School of Economics.
utilize forward-lookinig carbon metrics to measure and determine companies’ pathways relative to 3 benchmark scenarios defined by the Paris Agreement. Under TPI, companies are measured in 2 ways:
- the quality of companies’ governance and mgmt of their greenhouse gas GHG emissions
- carbon emission relative to international targets and national commitments as defined by the Paris Agreement.
Net Zero Asset Owner Alliance
- a group of international asset owners who have committed to achieving emissions neutral investment portfolios by 2050.
Net Zero Asset Mangers Initiative
Net Zero Company Benchmark
engages with the world’s largest corporate greenhouse gas emitters to drive action
The benchmark assesses corporate climate commitments based on publicly-available information to understand alignment to climate priorities and to support investor engagement action.
IPR Inevitable Policy Response
assumes that, in the current environment where the policy response to climate change is inadequate
Mercer and Ortec Finance approaches
Mercer - extends it climate-informed asset allocation process to sustainability-themed equity, private equity and real assets, including natural resources and infrastructure.
Ortec Finance -
integrates climate risks into financial scenarios, which include transition, physical and extreme weather impacts and pricing dynamics to cover all asset classes.
Approach for modelling the investment impacts of climate change
- climate change modelling and literature review
- risk factors and scenarios
- asset sensitivity
- portfolio implications
- portfolio implementation
in near term simulation 2020-2024
climate transition risks point to lower expected investment returns relative to the Paris-aligned pathways
Paris Orderly Transition gradually prices in lower earnings expectations across the 2020-2024 period, a Paris Disorderly Transition represents an earnings correction that produces a shock in 2024 and higher subsequent volatility.
later-term simulation 2025-2029
avg. inv. return in an orderly transition is similar to the climate-uninformed baseline where transition risk and physical risks are not modelled.
in contrast, both the Paris Disorderly and Failed Transitions point to lower expected investment returns.
Paris Disorderly Transition pathway
the sentiment shock occurring in 2025 and subsequent increase in volatility remain until 2026
Paris Failed Transition pathway
characterizing a business-as-usual-scenario that bring about a 4C temperature increase by 2100- leads to diminishing inv. returns as the impact of physical risk increases.
due diligence focuses on establishing baseline metrics to evaluate and compare managers. Metrics may include:
- the existence of an ESG policy
- affiliation with investor initiatives, such as the Principles for Responsible Investment PRI
- Accountability in the form of dedicated personnel and committee oversight
- the manner and degree in which ESG is integrated in the inv. process
- ownership and stewardship activities
- client reporting capabilities
Incorporating ESG into the manager selection process Sourcing evaluation approval on-going monitoring
Sourcing
- maintain a view on ‘best practices’ demonstrated by market leaders in the hedge fund space
- seek to identify market leaders within each individual hedge fund strategy peer group
Evaluation
- include ESG questions within its qualitative evaluation of a hedge fund manager during the initial meeting
- assess key areas of ESG integration as it pertains to a manager’s:
investment philosophy
investment strategy
investment process
team structure
Approval
- proprietary ESG scoring included in the manager tear sheet and reviewed by Manager Approval Group (MAG)
- ESG considerations noted in due diligence check list
- ESG policy reviewed
- Will not investment if the MAG determines that a material and relevant ESG risk cannot be sufficiently understood or qualified
Ongoing Monitoring
- research maintains an ESG score based on ongoing reviews
- risk team coordinates with relevant BlackRock teams to evaluate funds relative to various ESG criteria
- Operational Due Diligence requests updates on the ESG policy & approach in its quarterly monitoring process
- ESG considerations added to BAA’s qualitative heat map
multi-manager and FOF platforms are increasingly integrating their own ESG capabilities into more formal scoring frameworks
- for some platforms, these frameworks represent a spectrum of capabilities across diff. strategies
- for more sophisticated platforms, these frameworks have gone beyond simply informing the manager selection process to now acting as a formal factor or weight in the overall manager selection and allocation process
ESG consideration should be embed into
- at the highest level, asset allocation decisions
- portfolio exposure to non-financial factors
- risk management measures
- performance attribution
investment thesis includes:
role of analyst
- the intrinsic value of the security
- credit analysis
- the potential for a rerating or derating in valuation
- potential risks
- short-term and long-term catalysts
- an expectation on the security’s earnings growth and cash flow profile
role of pms, primary role is to weigh security-specific conviction against:
- macro and micro-economic data
- portfolio financial and non-financial exposure
- sensitivities to potential shocks
challenge: how to widen the focus of research and datasets largely optimized for security analysis into tolls that can be better inform portfolio and asset allocation analysis and decision-making, particularly in understanding where and how ESG contributes to risk-adjusted returns.
ESG framework should illustrate a continuity from micro-to-macro forms of analysis, including:
- the organizing principles and methodologies for ESG analysis
- the identification and analysis of financial and non-financial ESG materiality at the individual security level
- the approaches to build a composite picture of risks and exposure at a single portfolio level
- the representation of ESG risks and exposure that informs a mixed asset strategy which may include many different, underlying strategies
ESG in light of 2 dif. inv. strategies
Discretionary
Quantitative
Discretionary ESG inv. - fundamental
bottom up
Quantitative - rules-based approaches employing the statistical application of financial or/nonfinancial factors to drive securities selections.
quant seek to minimize higher cost associated with discretionary active mgmt
discretionary strategies often focus on depth within a portfolio, manifested through a portfolio of a few, more concentrated holdings, quantitative strategies focus on breadth
TCFD is principles-based framework providing recommendations for assessing climate risk and exposure
different approaches to measure carbon intensity have developed
Weighted-avg carbon intensity at the portfolio level
sum (current value of inv/
current portfolio value
* issuer’s scope 1 and scope 2 GHG emissions
/ issuer’s US$m revenue
SASB’s Materiality Map
is capable of assessing portfolio exposure to sustainability risks and opportunities across each issue
SBSB work around the Sustainable Industry Classification System SICS
modelled after the Global Industry Classification Standard (GICs)
offer an improved industry classification standard that speaks directly to ESG materiality.
Organize companies according to their sustainability attributes, such as resource intensity, sustainability risks and innovation opportunities.
platforms to upload portfolios 3rd ESG data provider
these platforms are capable of:
- illustrating a portfolio’s mean exposure and weighting toward low-, mid- , or high-scoring companies on ESG metrics
- producing a picture of the portfolio’s environment and carbon exposure on an absolute-value basis
- approximating an overall controversy or risk score for the portfolio
negative screening
- exclusions based on ethical preferences or around a normative worldview to shape the investable universe of a portfolio
often treated as irreconcilable
exclusions across 4 basis categories:
- universal
- conduct-related
- faith-based
- idiosyncratic exclusions
universal exclusions
represent exclusions supported by global norms and conventions like those from the UN and the WHO.
arms and munitions, nuclear weapons, tobacco, and varying degrees of exposure to coal-based power generation or extraction all qualify as universally accepted given normative support and the growing AUM they represent
Arms & munitions exclusions
- ottawa tready - anti personnel mine
- UN Convention on Cluster Munitions - use, stockpiling, production and transfer of cluster munitions
- UN Chemical Weapons Convention -use, stockpiling, production and transfer of chemical weapons
- UN Biological Weapons Convention -use, stockpiling, production and transfer of biological weapons
- treaty on the non-proliferation of nuclear weapon - limits the spread of nuclear weapons to the group of so-called Nuclear-Weapons States (USA, Russia, UK, France, China)
- Dutch Act on Financial Supervision ‘Besluit marktmisbruik’
