Ch. 8 ESG Integration and MGMT

Question 1

The endgame for ESG integration is

Answer 1

the combination of underlying ESG analysis to produce a more complete picture of ESG exposure and risk at the portfolio construction and management levels.

Exposure, risk, perf attribution, HL AA decision

Question 2

misperceptions when applying ESG at the portfolio

level. Accordingly, this chapter will attempt to address the following questions:

Answer 2

1. How can we characterise interest and demand for investment strategies in this area?
2. What exactly do we mean by ‘ESG strategies’, and how can we understand this approach within the broader language of responsible investment?
3. What are the assumptions underlying the claim for alpha generation and how can we extend them to include portfolio management and construction more generally?

Question 3

often conflate the terminology of

‘responsible investment’. they rarely, if ever, compete against one another

Answer 3

Exclusion, esg (stewardship), impact

Question 4

as per mercer report - which AC has highest and lowest level of progression on esg

Answer 4

high - infra
low - HF

Review Fig 8.2 +8.1

Question 5

as per mercer report - which AC has highest and lowest level of strategy availability of sustanability themed strategies

Answer 5

High - Infr/ RE
Low - HF/FI/ RE

Review Fig 8.2 +8.1

Question 6

Analysts need to justify their views in ‘a story’ or ‘investment thesis’ of
a security, this includes

Answer 6

▶ 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; and
▶ an expectation on the security’s earnings growth and cash flow profile.

Question 7

The role of portfolio managers, on the other hand, is of much broader scope. A portfolio manager constructs
and manages a portfolio through a careful process that aggregates all of the individual, underlying risks. And
while portfolio managers often form their own views-

Answer 7

role is to weigh securityspecific
conviction against:
▶ macro- and micro-economic data;
▶ portfolio exposure; and
▶ sensitivities to potential shocks.

Question 8

To this end, the ESG framework should illustrate a continuity from micro- to macro-forms of analysis, including:

Answer 8

▶ the organising 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; and
▶ the representation of ESG risks and exposure that informs a mixed asset strategy which may include many
different, underlying strategies.

Question 9

ESG integration can focus on risks as well as opportunities. A bias towards looking at one of these can lead to…

Answer 9

different return profiles at the portfolio level as the emphasis can shift from downside protection to upside
participation.

Question 10

ESG integration should be considered in light of two approaches

Answer 10

discretionary (typically fundamental) and quantitative (screening)
investment strategies.

Question 11

Broadly speaking, ESG external research and analysis can be categorised between…

Answer 11

academic research and
practitioner research. Each of these resources offers their own unique advantages and disadvantages for
investors.

Question 12

Accedmeic vs practitioner

Answer 12

academic studies on an individual basis
often end up disconnected from practice and are not widely or generally applicable - good for discussion and general trends cross regional.

Practitioner
research, on the other hand, is often less rigorous than academic work, and tends to be less conservative in its
assertion to correlate ESG with investment returns, sometimes ignoring other causal factors at play.

Including:

▶ sell-side research and analysis;
▶ academic studies;
▶ investment consultant research;
▶ third-party ESG data provider research;
▶ ESG-integrated fund distribution platforms;
▶ asset owner and asset manager white papers;
▶ investor initiative research;
▶ non-governmental organisations (NGOs) research;
▶ governmental agencies and central banks; and
▶ multilateral institutions and agencies.

Question 13

Portfolio managers may now treat carbon exposure on a portfolio-weighted basis (instead of company or per asset) as per the reco from TCFD. WACIM…

Answer 13

Weighted-average carbon intensity measures a portfolio’s exposure to carbonintensive
companies on a position-weighted carbon exposure.

Calculated as the carbon intensity (Scope 1 + 2 Emissions ÷ US$ million revenues) weighted for each position within a portfolio, this metric can be employed
by investors to tilt or overlay portfolios towards lower-carbon exposure.

Question 14

organise exclusions across four basis categories:

Answer 14

▶ universal;
▶ conduct-related;
▶ faith-based; and
▶ idiosyncratic exclusions.

Question 15

Universal exclusions represent…

Answer 15

exclusions supported by global norms and conventions like those
from the UN and the World Health Organization (WHO). It could be argued that controversial arms and munitions (cluster munitions and anti-personnel mines), 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 asset owner AUM they represent.

examples on pg. 352

Question 16

Conduct-related exclusions are generally…

Answer 16

ompany or country specific, and often not a statement against the nature of the business itself

Question 17

Faith-based exclusions are specific…

Answer 17

to religious institutional or individual investors

Question 18

Idiosyncratic exclusions are exclusions that are not…

Answer 18

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

Question 19

Exclusionary preferences are most commonly adopted and applied by…

Answer 19

asset owners rather than asset

managers.

Question 20

investors often assume..

Answer 20

a best efforts approach in these cases as some issues continue to remain difficult to reconcile from a screening perspective

Question 21

Another challenge is the treatment of asset classes and securities that…

Answer 21

outside of the traditional spectrum
of responsible investment, which has generally been focused on:

▶ listed equities;
▶ listed corporate debt; and
▶ real assets.

Question 22

Quasi ESG Factors - compare highest vs lowest rated funds

Answer 22

Highest 
- size (large) 
- ROE
- P/E
- growth
- Value
- P/B
- Quality
- Momentum
- Price momentum 
- Low volatility 
LOW

This is MCI (sustainalytics could be differnt)

Question 23

The linkage between quality and ESG as factors stems…

Answer 23

from the intuition that the governance of higher ESG-rated companies drives stronger decision-making around capital allocation and shareholder returns.

Question 24

what exactly is ESG?

Answer 24

If it can be quantified or measured, is it simply an amalgam of other established factors, like size and quality?

Question 25

Linkage from ESG to Large size

Answer 25

ransparency bias towards large companies favours ESG because a common characteristic of high-ranking ESG companies is strong transparency and disclosure. Large companies, not surprisingly, are better equipped and staffed to address these issues, resulting in higher ESG scores.

Question 26

One of the most exciting, yet least developed, areas in ESG integration is the

Answer 26

degree and means to which it can inform and shape the strategic asset allocation decision-making process and is the single most important top down decision (90% of variability of returns)

Question 27

ESG is most commonly | integrated at the...

Answer 27

security level, complemented by more recent, increasingly sophisticated efforts to express ESG risk at a composite portfolio level.

Question 28

if an allocator believes that ESG risk resides at the | underlying...

Answer 28

hen integrating ESG at the asset allocation level may prove a redundant exercise

Question 29

he allocator believes that ESG risk (e.g. climate risk) represents a top-down risk factor, then

Answer 29

integrating ESG within the asset allocation process makes sense in light of more specific climate implications

Question 30

greater coverage beyond equities and corporate fixed income has now made ESG integration at the strategic asset allocation level

Answer 30

more relevant

Question 31

STRATEGIC ASSET ALLOCATION MODELS AND THEIR SUITABILITY TO ESG - Table 8.4

Answer 31

MVO - sensitive to change in assumptions - ESG may impact volatility and return assumptions Factor allocation - could require change to baseline risk assumption - potential to build ESG as a factor Total Port Budget - focus on risk budgeting - more scenario analysis and flex to incorporate DAA - test assumptions over differnt time horizions LDI - could impact inflation and alter liability assumptions Regime switch model - capture shift in dynamics - not widley used by practitioners

Question 32

Insto Investro and climate change

Answer 32

Table 8.5

Question 33

Transition risks are...

Answer 33

These are the risks represented by legal, regulatory, policy, technology and market change in the transition to a low carbon economy

Question 34

Inevitable Policy Response (IPR)

Answer 34

may take shape through the introduction of economic incentives, such as a carbon tax or the formation of national carbon markets. It may also include other measures including more stringent environmental regulations requiring greater levels of mitigation-associated capital investment for highly exposed companies.

Question 35

ILLUSTRATIVE APPROACH FOR MODELLING THE INVESTMENT IMPACTS OF CLIMATE CHANGE

Answer 35

Table 8.6 and .7

Question 36

ESG IN MANAGER SELECTION

Answer 36

» the existence of an ESG policy; » affiliation with investor initiatives such as the 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; and » client reporting capabilities.

Question 37

it is important | to recognise that some asset classes and strategies face greater challenges than others

Answer 37

This may be because of the lack of quality datasets in some markets, particularly for some private markets, where equities and corporate credit have benefited the most from greater data availability and applications

Question 38

Order of ESG integration in Asset class

Answer 38

``` EQ FI (EMEA - highest globally) PE RE INFa HF ```

Question 39

FI integration

Answer 39

IG and EM - higher Integration Gov and HY - lower Table 8.11

Question 40

One way for PM to manage climate risk in Corp debt

Answer 40

one method available to a credit portfolio manager seeking to manage the long-term climate risk effects of an issuer is to invest in the issuer’s shorter-dated maturing debt.

Question 41

types of ESG bonds

Answer 41

Green - enviro Social - essential service Sustainable - more broad Blue - ocean

Question 42

level of correlation between ESG risk and Credit risk of Sovereign?

Answer 42

Modest = .62 table 8.15

Question 43

ESG challenges in PE

Answer 43

e lack of public transparency, established reporting standards, regulatory oversight and public market expectations around ESG and lack of require fin reporting

Question 44

ESG integration methods in PE

Answer 44

impose exclusionary screening on any number of criteria to restrict investment in certain sectors, either normatively or ethically defined. Hence, it is more likely that portfolio managers will apply some form of positive screening or thematic focus within its investment charter

Question 45

RE and Infa approach

Answer 45

▶ 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; and ▶ data validation and assurance

Question 46

Housing

Answer 46

carbon footprint of building (construction and maintenance) and exposure to extreme weather events

Question 47

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

Answer 47

would seem to support research efforts to identify and define ESG as a standalone factor Table 8.19

Question 48

Current ESG ratings should be viewed as

Answer 48

more normaising risk factors, directional not an absolute

Question 49

investors must | also consider the practical and operational issues when seeking to integrate ESG

Answer 49

``` More specifically, the asset class and regional exposure of a portfolio may have significant implications on the coverage and integration of the ESG screen. Equities strategies, particularly those in developed markets, with a focus on mid- to large-capitalisation companies, generally benefit from greater, more mature ESG research coverage by third-party data vendors. FI, corp is benfiting from more coverag - htough still a coverage gap in HY/Unlisted e ```

Question 50

two ways to address coverage gap

Answer 50

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. good up to 25% coverage gaps

Question 51

ESG sensitivity example

Answer 51

if the price of carbon on the European Union’s Emissions Trading System (ETS) suddenly appreciates, a portfolio’s exposure to companies such as utilities with a high dependency on coal-fired power generation will be at risk. This approach allows an investor to run simultaneous sensitivity analyses against ESG-related shocks, like the carbon price, to test the resilience and correlation of a portfolio

Question 52

One common criticism is ESG rankings reductive approach. In other words,

Answer 52

its quantitative measure does not consider softer forms of ESG, such as stewardship and engagement activities. In fact, an investor whose portfolio focuses on long-term, stewardship opportunities in poorly rated ESG companies in order to improve performance will likely suffer from the poor optics of these companies at the portfolio level. Another problem that may exist is the award of a high sustainability rating for a fund that may in fact not have any of the essential ingredients to ESG integration – such as an ESG policy or systematic process – embedded within its process

Question 53

How should ESG be viewed in a portfolio optimisation view

Answer 53

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

Question 54

X would be the easiest to optimism to ESG b/c of the more common rating and transparency

Answer 54

Carbon - and would maintain a high overlap in holding until restricted to >55% below BM where it starts to drop dramatically

Question 55

Holistic approach to ESG integration to

Answer 55

figure 8.25

Question 56

full ESG integration strategies often take greater efforts to:

Answer 56

▶ evidence internal and external research resources; ▶ document how ESG is embedded, typically in a process slide; ▶ track and report on engagement activities with company management; ▶ include portfolio exposure and weightings into sustainability themes like the SDGs; ▶ provide positive impact measurements of the portfolio against metrics like resource efficiency, water and energy consumption; and ▶ support the process with investment case studies.

Question 57

Exclusionary screening is the ...

Answer 57

is the oldest and simplest approach within responsible investment. Emerging under the moniker of socially responsible investment (SRI), the original objective was to impose a set of values or preferences to screen through an ethical or normative framework a portfolio’s exposure to specific sectors. May have impact on TE, active Share and factor exposure

Question 58

Positive alignment or best-in-class represents to some degree the ...

Answer 58

nverse of exclusionary screening. It employs a given ESG rating methodology to identify companies with better ESG performance relative to its industry peers. The diversity of ESG ratings methodologies and lack of ratings convergence are a key challenge these strategies face.

Question 59

``` a common criticism for best-in-class ESG strategies is that ... ```

Answer 59

their focus yields diminishing ESG returns with little opportunity to demonstrate incremental gains via active ownership efforts.

Question 60

Active ownership may leverage direct engagement between investor and company management

Answer 60

▶ encourage greater disclosure; ▶ improve transparency; and ▶ increase stronger awareness around ESG issues

Question 61

Impact investing describes strategies where the production

Answer 61

of a measurable positive social or environment impact is the primary investment objective. Impact investors represent diverse interests and expectations for financial returns.

Question 62

Impact reporting should include

Answer 62

▶ relevant product and services (revenue) exposure; ▶ regions, notably developing economies which the SDGs were originally designed for; ▶ sectors such as water utilities, renewable energy and healthcare; ▶ the relevance of supply chains; ▶ the additionality benefits of one or more of the SDGs, which may manifest in KPIs, such as job formation, renewable energy power generation and potable water production; and ▶ additional sustainable forms of agriculture and aquaculture table 8.27 examples report

Question 63

3 examples of insto investors using passive for ESG goals

Answer 63

California State Teachers’ Retirement System (CalSTRS) employs indices to meet ESG objectives and achieve lower cost and efficiency for its beneficiaries, which includes investment in the MSCI ACWI Low-Carbon Target Index.84 Taiwan’s Bureau of Labour Funds (BLF) pension scheme selected the FTSE4Good TIP Taiwan ESG Index for a five-year passive mandate.85 Japan’s Government Pension Investment Fund (GPIF), the world’s largest pension fund, is well known for its use of ESG-dedicated indices. This follows the creation of the Nikkei 400, which linked corporate governance reforms under Prime Minister, Shinzo Abe, to improved capital efficiency metrics like return on equity (ROE). GPIF’s indices include global and domestic environmental strategies, which overweight carbon-efficient companies as well as a socially-oriented index, the MSCI Japan Empowering Women Index. Table 8.14 illustrates the diversity of approaches and sources that GPIF has employed within its passive investment strategy. Table 8.14

Question 64

The wider availability of ESG data and greater investor interest in responsible investment has also led to the development of new, alternative approaches within passive investing. Single-factor ESG strategies

Answer 64

▶ ESG; ▶ climate and environmental markets; ▶ ethical and normative exclusions; and ▶ single ESG themes, like diversity as measured by female board representation.

Question 65

TYPICAL ESG INDEX CONSTRUCTION - table 8.30

Answer 65

parent method governance underpinned by ESG data

Question 66

screening impact on TE by sectors

Answer 66

FF impact income and value highest sinn has impact on growth Table 8.31

Question 67

passive strategy engagement

Answer 67

While passive investment strategies are capable of proxy voting, the nature of their strategies innately limits their ability to engage with portfolio companies unless coordinated by an established stewardship team. One implication of this is that passive investing may translate into shallower forms of stewardship activities

Question 68

academic research examining the performance considerations | and trade-offs of ESG integration into passive portfolio management remains

Answer 68

relatively scarce (low trade off)