Chapter 8 - ESG Integrated Portfolio Construction and Management Flashcards
Dynamic Asset Allocation
(2 Points)
- investment strategy based on long-term asset allocation, but employing short-term tactical trading to maintain investment allocation targets
- continual rebalancing over short-term periods may dimish the value of ESG integration
Strategic Asset Allocation
Constructed over a multi-decade period and therfore warrants long-term consideration of financial and nonfinancial ESG effects, like Climate Risk.
Strategic Asset Allocation Models
(6 Points)
- Mean-Variance Optimization (MVO)
- Factor Risk Allocation
- Total Portfolio Analysis (TPA)
- Dynamic Asset Allocation (DAA)
- Liability Driven Asset Allocation
- Regime Switching Models
Mean-Variance Optimization (MVO)
(4 Points)
- MVO is a mix of assets that produce minimum standard deviation (risk) for maximum level of expected returns
- Black-Litterman Global Asset Allocation is an MVO model
- sensitive to revised assumptions from ESG considerations
- ESG issues could have impact on assumptions for expected return, volatility and correlation
Factor Risk Allocation Strategy
(4 Points)
- seeks to build diversified portfolio based on sources of risk
- typically include factors such as fundamental risks (GDP, interest rates, inflation) and market risks (equity risk premium, illiquidity, volatility)
- ESG-related risk factors (e.g. climate risk) could help to improve diversification of risks
- links to ESG issues are more difficult to quantify with precision
Total Portfolio Analysis (TPA)
(4 Points)
- based on agreed risk budget, asset allocations are made on expected risk exposures
- requires specialist knowledge to make informed judgments about future risk
- relevant to consider ESG issues which require interplay between judgment about future and quanitative analysis
- TPA provides greater flexibility to incorporate ESG issues
Issues of Liability Driven Asset Allocation
(4 Points)
- Liability Driven Investment (LDI) seeks to find most efficient asset class mix driven by funds liabilities
- concerned with return of assets, change in value of liabilites and how assets and liabilities interact to determine overall portfolio value
- sensitive to revised assumptions from ESG considerations
- ESG issues could impact inflation and alter liability assumptions
Regime Switching Models
(5 Points)
- model abrupt and persistent changes in financial variables due to shift in regulations, policies and other secular changes
- relevant to consider ESG issues where abrupt shift is ecpected over time
- typically based more on forward looking data, then historical data
- potential to capture dramatic shifts in investment environment
- not yet widely used by investment practitioners
Portfolio Risk Portions
(2 Points)
- isolated risk of individual asset or individual investment strategy
- correlation risk that emerges from combination of all assets and strategies
Black-Litterman Asset Allocation Model (BLM)
(4 Points)
- BLM is more intuitive and doesn’t require return estimates for each asset class, in comparison to Markowitz-derived MVO approach
- better accommondate areas like pricing climate risk
- Mean-Variance Optimization (MVO) model
- most promising asset allocation framework approach
Initiatives for Portfolio Management
(5 Points)
- Paris Aligned Investment Initiative (PAII)
- Transition Pathway Initiative (TPI)
- Net Zero Asset Owner Alliance
- Net Zero Asset Managers Initiative
- Net Zero Company Benchmark
Paris Aligned Investment Initiative (PAII)
(4 Points)
- launched 2019 by Institutional Investor Group on Climate Change (IIGCC)
- European asset owner-coordinated and led initiative
- develop methodologies and assessment tools related to aligning investment portfolios to the Paris Agreement
- Net Zero Investment Framework: defines elements of a net zero strategy and offers recommended approaches and actions for investors to measure and align portfolio to net zero emissions
Transition Pathway Initiative (TPI)
(7 Points)
- established 2017 in partnership with Grantham Research Institute on Climate Change and Environment at the London School of Economics
- global asset-owner driven, asset-manager supported, initiative
- supports transition towards low-carbon economy
- datasets and tools that utilize forward-looking carbon metrics to measure and determine companies’ pathway relative to the three benchmark scenarios defined by Paris Agreement
- companies are measured in 2 ways:
1. quality of companies’ governance and management of their GHG emissions
2. carbon emission relative to international targets and national commitments as defined by the Paris Agreement
Net Zero Asset Owner Alliance
(5 Points)
- launched 2019 as an alliance brought together by the United Nations
- group of international asset owners
- commited to achieving emission neutral investment portfolios by 2050 or sooner
- supporting global efforts to limit temperature rises to 1.5°C
- 2025 Target Setting Protocol: outlines how asset owners calculate and establish climate targets within portfolios and allocate capital towards decarbonization efforts
Net Zero Asset Managers Initiative
(4 Points)
- launched 2020
- group of international asset managers
- support the goal of net zero GHG emission by 2050 or sooner, in line with Paris Agreement of limiting temperature rise to 1.5°C
- signatories (asset managers) also commit to support investing aligned with net zero emission by 2050 or sooner
Net Zero Company Benchmark
(5 Points)
- launched 2020 by Climate Action 100+
- investor-led initiative
- engages with world largest corporate GHG emitters to drive action
- benchmark assesses corporate climate commitments based on publicly-available information
- understand alignment to corporate climate priorities (strong governance, reduce GHG emissions and improve corporate disclosure) and support investor engagement action
Inevitable Policy Response (IPR)
(3 Points)
- current policy response to climate change is inadequate, therefore governments may respond to increasing climate-borne damage in sudden reflex reaction
- might include economic incentives (carbon tax, national carbon markets) or more stringent environmental regulations
- speed and scope of transition risk may carry considerable implications for an investment portfolio
Mercer Climate Scenario Model
(3 Points)
- integrating climate scenario model into long-term strategic asset allocation methodology that extends to 2100
- Mercer’s report “Investing in a Time of Climate Change” addresses need to enlarge asset allocation models beyond equities
- Mercer report extends its climate-informed asset allocation process to sustainability-themed equity, private equity and real assets (incl. natural resources and infrastructure)
Ortec Finance Climate Scenario Model
(4 Points)
Integrates climate risks into financial scenarios, including:
* transition risk
* physical and extreme weather impacts
* pricing dynamics to cover all asset classes
Due Diligance Metrics for Portfolio Manager Selection
(6 Points)
- existence of an ESG policy
- affiliation with investor initiatives, such as Principles for Responsible Investment (PRI)
- accountability in form of dedicated personnel and committe oversight
- manner and degree in which ESG is integrated in investment process
- ownership and stewardship activities
- client reporting capabilities
ESG Integration embeds ESG Considerations into…
(4 Points)
- …the highest level asset allocation decisions
- …portfolio exposure to non-financial factors
- …risk management measures
- …performance attribution
Factors of Analysts’ Investment Thesis of a Security
(6 Points)
- intrinsic value of the security
- credit analysis
- potential for a re-rating or de-valuation in valuation
- potential risks
- short-term and long-term catalysts
- expectation on security’s earnings growth and cash flow profile
Roles of Analysts in ESG Integration
(8 Points)
Justify their views in investment theory with different factors:
* intrinsic value of security
* credit analysis
* potential for a re-rating or de-valuation in valuation
* potential risks
* short-term and long-term catalysts
* expectation on security’s earnings growth and cash flow profile
ESG increasingly recognized element within securities analysis and carry meaningful implications that help investment thesis if material enough.
Roles of Portfolio Managers in ESG Integration
(6 Points)
- constructs and manages portfolio through careful process that aggregates all individual underlying risks
- weight security-specific conviction against:
1. macro- and micro-economic data
2. portfolio financial and non-financial exposure
3. sensitives to potential shocks - ESG, if properly and systematically integrated, should be considered in same light as these other factors
ESG Integration in 2 Investment Strategies
(9 Points)
Discretionary ESG Investment Strategy:
* portfolio manager does bottom-up financial analysis alongside consideration of ESG factors to einforce investment thesis
* work to understand aggregate risk at portfolio level across all factors to understand correlation, event risk and potential shocks to the portfolio
* focus on depth within portfolio, through portfolio of few more concentrated holdings
Quantitative Investment Strategy:
* rules-based approach employing statistical application of financial and/or non-financial factors to drive securities selection
* quantitative strategies seek to minimize higher costs associated with discretionary strategies
* focus on breadth of portfolio, using larger portfolio of holdings to target risk and volatility-adjusted returns
* weighting ESG in a multi-factor stock selection, including idiosyncratic factors
2 External ESG Research Resources
(6 Points)
Academic Research:
* 2000 academic studies indicate overall positive bias between ESG and investment returns
* academic studies on individual basis often end up disconnected from practice and are not widely and generally applicable
* often unhelpful for practicioners who search for cross-regional and cross-temporal factors or frameworks that can be universally applied to portfolios
Practitioner Research:
* less rigorous than academic work and tend to be less conservative in its assertion to correlate ESG with investment returns, sometimes ignoring other causal factors at play
Investment Practitioner Research Sources
(10 Points)
- 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
- NGOs research
- government agencies and central banks
- multilateral institutions and agencies
Third-Party ESG Data Provider Online Platform Capabilities
(4 Points)
- upload portfolio to see stock-specific risks on a number of potential ESG metrics
- illustrating portfolio’s mean exposure and weighting towards low-, mid- or high-scoring companies on ESG metrics
- producing a picture of portfolio’s environmental and cabron exposure on absolute-value basis (e.g. expressed as weighted-average cabron intensity)
- approximating overall controversy or risk score for portfolio
Task Force on Climate-Related Financial Disclosures (TCFD)
(6 Points)
- portfolio managers now treat carbon exposure on a porfolio-weighted basis
- weighted carbon intensity (Scope 1+2+3 Emissions per USD million revenues)
- principle based framework providing recommendations for assessing climate risk and exposure
- because it’s not compulsory, different approaches to measure carbon intensity have developed; e.g.:
1. EU Sustainable Finance Disclosure Regulation (SFDR) accounts for Scope 1, 2 and 3 emission
2. UK TCFD practice focuses only on Scope 1 and 2 emissions
Sustainability Accounting Standards Board (SASB)
(3 Points)
- framework and materiality map covers issuer-specific materiality as well as overall porfolio exposure
- covering equities, fixed income, private equity and real assets
- capable of assessing portfolio exposure to sustainability risks and opportunities across each issue
Sustainable Industry Classification System (SICS)
(4 Points)
- developed by SASB
- modeled after Global Industry Classification Standard (GICS)
- offers improved industry classification standard that speaks directly to ESG materiality
- organizes companies according to their sustainability attributes, such as resource intensity, sustainability risks and innovation opportunities
Exclusion-Based ESG Investment Approaches (Screening)
(4 Points)
- Universal Exclusions
- Conduct-Related Exclusions
- Faith-Based Exclusions
- Idiosyncratic Exclusions
Universal Exclusions
(2 Points)
- supported by global norms and conventions, like UN and WHO
- e.g. 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
Conduct-Related Exlusions
(2 Points)
- generally company or country-specific and often not a statement against the nature of the business itself
- e.g. companies that violate International Labour Organization (ILO) principles
Faith-Based Exclusions
Specific to religious instutional or individual investors, faith-based exclusions refer to the exclusion of certain industries or companies from an investment portfolio based on religious or ethical beliefs, such as avoiding investments in alcohol, tobacco, gambling, or weapons industries.
Idiosyncratic Exclusions
(2 Points)
- exclusions that are not supported by global consensus
- e.g. NZ pension funds are bound by law to exclude companies involved in processing of whale meat products
