ESG Integrated Portfolio Construction

Question 1

Traditionally speaking how do institutional investors manage systemic macro-economic factors? How is this different than strategic asset allocation?

Answer 1

By coupling asset allocation strategies with asset/liability management (or ALM) which provides investors the tools with which to match the cash flows of assets to payment of liabilities.

Where as strategic asset allocation establishes return targets across asset classes (equities, fixed income, real assets, etc.) and investment strategy types (i.e. alternatives).

Question 2

What is the difference between strategic asset allocation and dynamic asset allocation? Which is better from an ESG perspective?

Answer 2

A strategic asset allocation approach is constructed over a multi-decade period representing several economic cycles, an investment timeframe that clearly warrants the long-term consideration of financial and non-financial ESG effects like climate risk.

Dynamic asset allocation, on the other hand, establishes an initial asset allocation mix with the aim to continually review and recalibrate this allocation mix under much shorter intervals using traditional factors to maintain the original target mix. The potential risk with continual rebalancing in shorter time intervals may ultimately diminish the value of ESG integration in dynamic asset allocation.

Greater coverage beyond equities and corporate fixed income has now made ESG integration at the strategic asset allocation level more relevant.

Question 3

Why has ESG’s relevance tended to be muted or at
best underrepresented within multi- and mixed-asset allocation?

Answer 3

Historically ESG has been best understood from an equities perspective. As ESG research improves and a better quantitative understanding of ESG risk implications to the extension into other asset classes beyond equities
and fixed income, its relevance within a multi-asset allocation context should increase.

Question 4

Portfolio risk can be divided into two portions, what are they and how do they correspond to ESG integration?

What is the most material ESG factor for institutional investors to address within asset allocation strategies?

Answer 4

1) isolated risk of an individual asset or strategy
2) correlation risk that emerges from the combination of assets and/or strategies

Climate change => climate risk is both systemic and company specific

Fun Fact: As well as being one of the key recommendations of the 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.

Question 5

What is Inevitable Policy Response (IPR)?

Answer 5

IPR assumes that, in the current environment where the policy response to climate change is inadequate – ‘business as usual’ – governments may potentially respond to increasing climate-borne damage in a sudden reflex reaction.

The nature and magnitude of IPR may carry considerable implications for an investment portfolio, particularly in the speed and scope of transition risk. Hence, the development of more sophisticated approaches designed
to understand the sensitivity of an investment portfolio to climate policy-related shocks and simulations are warranted as risk measures.

Question 6

What factors need to be considered by investors when integrating ESG into multi-manager strategies or manager selection?

Answer 6

▶ 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 investment process
▶ ownership and stewardship activities
▶ client reporting capabilities

Question 7

What should be the aspirations for ESG at the portfolio level?

Answer 7

A combination of top-down analytics and underlying ESG analysis to produce a more complete picture of ESG exposure and risk at the portfolio construction and management levels. This includes:
▶ at the highest level, asset allocation decisions
▶ portfolio exposure to non-financial factors
▶ risk management measures
▶ performance attribution

Fun Fact: Data compiled by Mercer Consulting suggests that progress in ESG integration is marked by a high degree of variation depending on asset class and investment strategy type.

Question 8

What is the challenge that portfolio managers face with respect to ESG integration using research and datasets?

Answer 8

They are largely optimised for security analysis into tools that can better inform portfolio and asset allocation analysis, particularly in understanding where and how ESG contributes to risk-adjusted returns.

To this end, the ESG framework should illustrate a continuity from micro- to macro-forms of analysis, including:
▶ Organising principles and methodologies for ESG analysis;
▶ The identification and analysis of financial and non-financial (ESG) materiality at the individual security level;
▶ Build a composite picture of risks and exposure at a single portfolio level;
▶ Build a mixed asset strategy which may include many different, underlying strategies

Question 9

Compare ESG integration across a Discretionary investment strategy vs a
Quantitative investment strategy?

Answer 9

ESG integration in discretionary approaches is process-oriented, while quantitative approaches, are generally rules-based and factor-oriented.

Question 10

What is weighted-average carbon intensity and how is it calculated at the security level? What about the portfolio level?

Answer 10

WACI measures a portfolio’s exposure to carbon-intensive companies on a position-weighted carbon exposure basis. Calculated as the Scope 1 + 2 Carbon Emissions ÷ US$ million revenues for each position within a portfolio.

For portfolio level , Sum of (multiply the above by current value of investment /current value of portfolio.

Question 11

What is Sustainable Industry Classification System (SICS)?

Answer 11

Modelled after the Global Industry Classification Standard (GICS), the SICS system organises companies according to their sustainability attributes, such as resource intensity, sustainability risks, and innovation opportunities.

SASB developed SICS as an improved industry classification standard that speaks directly to ESG materiality.

Question 12

What is the rationale for asset managers to develop more sophisticated ESG analytics platforms in-house?

Answer 12

The rationale stems from:

• the interest in safeguarding portfolio holdings – particularly
  with regard to clients’ segregated investment mandates
• also in demonstrating a differentiated approach to understanding and reporting portfolio data.
• in response to the subjectivity and divergence among ESG ratings
  providers
• developing an approach that incorporates both third party and proprietary ESG data lowers an overreliance to a single provider and creates greater context for discussion when reviewing the risk profile of a
  portfolio.
• Portfolio tools provide investors with the ability to stress test a portfolio against different ESG criteria (such as a sudden, hypothetical increase in the price of carbon emissions) to understand the sensitivity of the portfolio.

Question 13

What are the 4 main categories of exclusions based investing?

Answer 13

1. universal- represent exclusions supported by global norms and conventions like those from the United Nations (UN) and the World Health Organization (WHO).
2. conduct-related- generally company or country-specific, and often not a statement against the nature of the business itself. Labour infractions in the form of violations against the International Labour Organization (ILO) principles for example.
3. faith-based- are specific to religious institutional or individual investors.
4. idiosyncratic exclusions- Uncommon exclusions that are not supported by global consensus. For example, New Zealand’s pension funds are singularly bound by statutory law to exclude companies involved in the processing
   of whale meat products.

Fun Fact: Exclusionary preferences are most commonly adopted and applied by asset owners rather than asset managers. While there are certainly asset managers who have formally instituted some form of values-based
exclusionary screens, they currently represent a small minority.

Question 14

What are transition bonds?

Answer 14

Transition bonds provide financing to ‘brown’ industries with high GHG emissions (such as mining, utilities and heavy industry) to allow these sectors to raise capital designated to the transition towards greener industries.

Because of this fossil fuel exposure, these sectors are generally excluded from raising capital in sustainable finance markets.

Question 15

What are green bonds? Name the universal green bond framework?

Answer 15

Sometimes referred to as climate bonds, are any type of bond instrument that funds projects that provide a clear benefit to the environment, such as renewable energy projects.

There is none - some common ones include EU Green Bond Standard, Green Bond Principles

Question 16

What is green securitization?

Answer 16

Green securitisation represents the mutualization of illiquid, ‘green’ assets or a series of assets into a security.

Green collateralized loan obligations (CLO), for which data that can be easily quantified and screened exists, constitute one such mutualised form of green securitisation.

Question 17

What does the the World Bank’s World Governance Indicators consider when evaluating sovereign debt?

Answer 17

a country’s governance score; and its rankings on:
» political stability;
» voice and accountability;
» government effectiveness;
» rule of law;
» regulatory quality; and
» control of corruption.
shows a significant correlation between country ESG risk and credit ratings, supporting the theory that ESG may be a leading indicator or at the very least a supporting factor for stable economies.

Note: The Worldwide Governance Indicators (WGI) project reports aggregated and individual governance indicators for over 200 countries and territories over the period 1996–2017 for six dimensions of governance.
These aggregate indicators combine the views of a large number of enterprise, citizen and expert survey respondents in industrial and developing countries. They are based on over 30 individual data sources
produced by a variety of survey institutes, think tanks, non-governmental organisations, international organisations and private sector.

Question 18

Name some challenges in ESG integration for private markets?

Answer 18

• lack of public transparency and established reporting standards
• little regulatory oversight
• less market expectations around ESG
• capacity challenges for smaller firms
• lack or clear, consistent, meaningful data
• ## potential challenges with early stage shareholders and founding team

Question 19

What is GRESB, what is it used for and what does its benchmark report show?

Answer 19

Global Real Estate Sustainability Benchmark is geared towards real assets like real estate and infrastructure. Its full benchmark report provides a composite of:
▶ peer group information;
▶ overall portfolio KPI performance;
▶ aggregate environmental data in terms of usage and efficiency gains;
▶ a GRESB score that weights management, policy and disclosure;
▶ risks and opportunities, monitoring and environmental management system (EMS);
▶ environmental impact reduction targets;
▶ data validation and assurance

**this report depends heavily on companies, funds and assets participating in the GRESB reporting assessment process. For portfolios where a significant percentage of the fund’s holdings do not participate in the GRESB assessment, portfolio managers will need to supplement with their own ESG scoring.

Question 20

What are some issues with integrating ESG into portfolio analysis for the purposes of managing risk?

Answer 20

Outside of absolute value-based metrics like weighted-average carbon intensity, subjective ESG scores and rankings will continue to represent the prevailing means to approximate ESG risk in a portfolio.

Studies demonstrating that almost 80% of alpha (returns in excess of market performance) can be attributed to portfolio factor risk rather than stock-specific risk, would seem to support research efforts to identify and define ESG as a standalone factor but ESG is still largely characterised by its process-oriented approach for much of the investment management industry. This remains distinct from traditional approaches to risk.

Question 21

Describe quant approaches to ESG integration?

Answer 21

Two common approaches are multi-factor and multi-factor strategy.

ESG operates much like any other factor within a multi-factor algorithmic investment strategy where quantitative managers build proprietary multi-factor models often based on a combination of well- established factors and more idiosyncratic (stock-specific) factors. Each factor is prescribed an individual weight which in turn proportionally drives the multi-factor signal. One of the advantages of a multi-factor model over a smart beta or beta plus strategy is diversification.

A multi-factor strategy, on the other hand, seeks to maximise the benefits of diversification through the combination of a number of different factors. This is generally accomplished by allocating to factors on a top-down basis, or on a bottom-up basis by allocating to individual securities that share certain common factor
attributes. Factors that are negatively correlated to one another are combined to produce greater portfolio protection against a potential reversal by any one given factor.

Question 22

How should investors treat ESG coverage gaps in portfolios?

Answer 22

No best practice currently exists in terms of how to treat ESG coverage gaps within a portfolio. However, there are two potential approaches to address this issue:
1. The simplest approach is to simply rescale the scoreable portion of the portfolio to 100% by proportionally resizing each scoreable position.

2. The second approach is to apply Bayesian inference to the coverage ratio, effectively grossing it up to 100% by probabilistic inference.

Question 23

What are the primary purposes of EU’s Sustainable Finance Disclosure Regulation?

Answer 23

EU legislation marks a distinct shift away from self-regulation towards a top-down, EU-driven organisation of economic activities defined as sustainable investments. Broadly speaking, the policy objectives are to:
▶ provide protections against greenwashing for investment products sold into the EU;
▶ further embed sustainability within risk management for all investment products;
▶ direct capital towards sustainable investment activities and away from unstainable investment activities to support the EU’s commitment towards a 2050 climate neutral economy.

Question 24

What are the components of the The EU Sustainable Finance Action Plan?

Answer 24

Two major components, each with subcomponents-

EU Taxonomy - Organizes economic activity into a classification system of environmentally sustainable activities.

Sustainable Finance Disclosure Regulation - SFDR focuses on disclosure at the entity (manager) and the product (investment strategy) levels. It organizes certain sustainability focused investment products into 3 major groups:
1. Article 9 or ‘dark green’ funds are products that have sustainable investment as their objective. As defined under the SFDR, sustainable investment may either contribute an environmental or social objective.
2. Article 8 or ‘light green’ funds are products that more broadly promote environmental and/or social characteristics. While taking ESG criteria into consideration as one factor among many, they do not have to make sustainable investment the defining objective.
3. Article 6 or ‘Other’ funds describes those funds that do not actively promote sustainable investment objectives or integrate sustainability criteria in ways that can be overtly marketed as such. These funds may however integrate ESG as a way to manage risk.

Question 25

What are the 6 steps outlined by the PRI for the implementation of an ESG screening investment approach?

Answer 25

1. Identify client priorities - Investors should clearly define in fund docs.
2. Publicize clear screening criteria - Investors should disclose screening objectives in contractual agreements/IMA’s ( investment mgmt agreements)
3. Introduce oversight: Investors should establish internal controls or compliance functions that
   a. oversees screening
   b. conducts reviews
   c. considers changes in screening criteria
4. Adapt investment approach: investors may want to refine the screening approach with greater sophistication and/or flexibility consistent with the fund documentation. Depending on the desired portfolio exposure, investors may choose to employ absolute, threshold or relative exclusion methodologies.
5. Review portfolio implications: investors should regularly assess and review the implications of screening on the portfolio including changes in exposure to volatility, tracking error and common risk factors.
6. Monitoring, reporting and audit: investors should implement process and data assurance control functions that are either internally or even externally (third party) assured.

Question 26

For individual company screening should a relative or absolute basis be utilized?

Answer 26

ESG screening premised on relative and peer-group datasets provides better context for building and maintaining a balanced, diversified portfolio. This approach potentially prevents wholesale exclusions of poorly-rated industries like mining on absolute value-based data, which may represent not only a meaningful driver of the economic cycle, but a significant weighting within main indices.

As we have discussed before, exclusions of this nature contribute to lower diversification and consequently, higher active risk within a portfolio.

Question 27

What is ESG portfolio optimization and how is it accomplished?

Answer 27

Portfolio optimisation allows portfolio managers to target a specific ESG rating or environmental objective, such as carbon emissions reduction, while simultaneously managing the portfolio to tracking error range.

The process of portfolio optimisation requires defining an upper and lower bound for a given ESG variable and then applying it on an absolute or benchmark relative basis.

Note: ESG integration should not be seen as detrimental to the risk–return dynamic of portfolio optimisation. Rather, it should be understood as simply another factor that potentially may enhance the risk and return profile. Like other ESG considerations, its construction and weighting in the context of the overall portfolio ultimately rests on how high a priority the investor assigns it, relative to other factors.

Question 28

What is ESG optimization?

Answer 28

ESG optimisation is the organisation of securities by their individual ESG profile to solve a specific ESG optimisation at the overall portfolio level.

Question 29

Full ESG integration strategies often take which efforts to accomplish?

Answer 29

• Evidence internal and external ESG research resources
• Document how ESG is imbedded in the ESG research process
• Track and report on management engagement activities
• Include portfolio exposure and weightings into sustainability themes such as SDG’s
• Track and report on positive impact measurements such as resource efficiency, water consumption, etc
• support process with case studies

Question 30

Under the DNSH (Do No Significant Harm) principle in the Technical Expert Group Final Report on the EU Taxonomy, economic activities that make a substantial environmental contribution to the climate change mitigation or adaptation must not
cause significant harm to the other designated environmental objectives. These include:

Answer 30

• sustainable use/protection of water resources
• waste prevention and recycling/ circular economy
• pollution prevention
• healthy ecosystems

Question 31

List some challenges to a best-in-class ESG integration approach?

Answer 31

• Diminishing ESG returns
• Because of this score-imposed constraint, best-in-class strategies will generally have much less latitude to perform and apply proprietary research on lower-scoring companies that happen to exhibit positive momentum or improvement in their ESG metrics. (aka screening out potential up and comers )
• The diversity of ESG ratings methodologies and lack of ratings convergence are a key challenge these strategies face.

Question 32

Name some common thematic sustainable investing themes? Name some challenges to this style of ESG integration?

Answer 32

Notable themes include:
- clean energy
- healthcare
- water
- demographic changes

Challenges recognized are the focus on a singular theme sacrifices benefits of portfolio diversification. Similarly this style is subject to higher tracking errors and higher volatility.

Question 33

Potential pitfalls of passive ESG investing?

Answer 33

• Reliance on inadequate data sets
• ESG disclosure is still largely voluntary with little convergence on global accounting standards
• Methodologies are highly subjective, individualistic and interpretive
• Reliance on third party data/ratings providers can offer confusing ESG integration approaches
• Not focused on engagement/stewardship since the nature of this strategy innately limits their ability to engage with portfolio companies unless coordinated by an established stewardship team.

Question 34

Name some macro-climate considerations by asset class?

Answer 34

Equities - senstitive to climate impacts on economic performance

Bonds - sensitive to climate impacts on issuers creditworthiness
- sensitive to fiscal policy related to climate challenges

Alts - Better diversification from climate risks
- harder to assess climate risk exposure