CFA Institute Chapter 8: Integrated Portfolio Construction and Management PDF

© CFA Institute. For candidate use only. Not for distribution. CHAPTER 8 Integrated Portfolio Construction and Management LEARNING OUTCOMES Mastery The candidate should be able to: 8.1.1 explain the impact of ESG factors on strategic asset allocation 8.1.2 describe approaches for integrating ESG into the portfolio management process 8.1.3 explain approaches for how internal and external ESG research and analysis is used by portfolio managers to make investment decisions 8.1.4 explain the different approaches to screening and the benefits and limitations of the main approaches 8.1.5 explain the main indexes and benchmarking approaches applicable to sustainable and ESG investing, noting potential limitations 8.1.6 apply ESG screens to the main asset classes and their sub-sectors: fixed income; equities; and alternative investments 8.1.7 distinguish between ESG screening of individual companies and collective investment funds: on an absolute basis; relative to sector/peer group data 8.1.8 explain how ESG integration impacts the risk–return dynamic of portfolio optimization 8.1.9 evaluate the different types of ESG analysis/SRI investment in terms of key objectives, investment considerations, and risks: full ESG integration; exclusionary screening; positive alignment/best-in-class; active ownership; thematic investing; impact investing; other 8.1.10 describe approaches to managing passive ESG portfolios 448 Chapter 8 1 © CFA Institute. For candidate use only. Not for distribution. Integrated Portfolio Construction and Management INTRODUCTION TO INTEGRATED PORTFOLIO CONSTRUCTION AND MANAGEMENT Environmental, social, and governance (ESG) integration occurs at different levels of the investment process, each necessitating its own framework for analysis and implementation. Where previous chapters have described ESG integration at the underlying security level, this chapter examines different approaches, research, and methodologies for integrating ESG assessment at higher levels of the investment decision-making process, starting at strategic asset allocation (SAA) and moving on to portfolio construction and management. Much of the existing evidence supporting ESG integration draws upon single security and issuer case studies. The fact that ESG integration is comparatively less developed as investors elevate the decision-making process to higher levels — asset allocation, fund manager selection, and portfolio investment — makes it an exciting area for innovation. This is particularly true as investors build more robust ESG capabilities outside of the traditional equities focus of ESG. These areas include: ► mixed assets; ► real assets; and ► sovereign debt. Nonetheless, investors should recognize the trade-offs — both explicit and implicit — to risk-adjusted returns when integrating ESG screening approaches. Accordingly, this chapter draws upon portfolio management theory complemented with examples of investment best practices to: 2 ► discuss research, approaches, and challenges to embedding ESG investing risk into global asset allocation models; ► examine how ESG investing can be applied to approaches across asset classes and different strategy types; ► consider how ESG can leverage quantitative research methods to understand risk exposure and performance return dynamics in portfolios; and ► differentiate between actively and passively managed ESG strategies. INTEGRATING ESG: STRATEGIC ASSET ALLOCATION MODELS 8.1.1 explain the impact of ESG factors on strategic asset allocation One of the most exciting, yet least developed, areas in ESG integration is the degree and means to which it can inform and shape the strategic asset allocation decision-making process. For asset owners and multi-asset managers, asset allocation represents the most important, top-down decision that will carry wide-ranging implications depending on exposure to asset classes and investment strategy types. Indeed, the strategic asset allocation policy may account for as much as 90% of the variability in investment returns of a typical fund over time.1 1 Ibbotson, R.G., and P.D. Kaplan. 2000. “Does Asset Allocation Policy Explain 40, 90, or 100 Percent of Performance?” Financial Analysts Journal 56 (1): 26–33. Available at: www.jstor.org/stable/4480220 © CFA Institute. For candidate use only. Not for distribution. Integrating ESG: Strategic Asset Allocation Models Traditionally, institutional investors have managed systemic, macro-economic factors by coupling asset allocation strategies alongside asset/liability management (ALM). Where strategic asset allocation establishes return targets across asset classes (equities, fixed income, real assets, etc.) and investment strategy types (i.e., alternatives), ALM provides investors the tools with which to match the cash flows of assets to payment of liabilities. For example, both of these elements are vital for the sustainability of a pension fund’s risk-adjusted returns and its ability to pay out pension benefits for its beneficiaries.2 A considerable misalignment exists between investors’ traditional efforts, which emphasize integrating ESG in individual securities, assets, and companies, and the much broader, systemic exercise of strategic asset allocation. As discussed in both Chapter 7 of this book and later on in this chapter, ESG is most commonly integrated at the security level, complemented by more recent, increasingly sophisticated efforts to express ESG risk at a composite portfolio level. As a consequence, asset allocators often cede responsibility for active ESG integration to these underlying levels. Said another way, if an allocator believes that ESG risk resides at the underlying, security selection level, then integrating ESG at the asset allocation level may prove a redundant exercise. If, on the other hand, the allocator believes that ESG risk (e.g., climate risk) represents a top-down risk factor, then integrating ESG within the asset allocation process makes sense in light of more specific climate implications (e.g., coastal retreat to coastal property exposure). Different asset allocation approaches carry important implications for the degree of ESG integration. 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 (or tactical) 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. However, there is a risk that continual rebalancing in shorter time intervals may ultimately diminish the value of ESG integration in dynamic asset allocation. It could be argued that one result of the emphasis of ESG integration on equities exposure (versus other asset classes) is the relative underdevelopment of other asset classes and investment strategies. Challenges clearly exist in many alternative areas, but greater coverage beyond equities and corporate fixed income has now made ESG integration at the strategic asset allocation level more relevant. In addition, ESG research on top-down strategic asset allocation has tended to focus on environmental criteria, essentially exposure and sensitivity to assumptions around climate risk rather than through a broader ESG lens. 2 Bohne, A., and M. Elkenbracht-Huizing. 2018. The Handbook of ALM in Banking: Managing New Challenges for Interest Rates, Liquidity and the Balance Sheet. London: Risk Books. 449 450 Chapter 8 © CFA Institute. For candidate use only. Not for distribution. Integrated Portfolio Construction and Management Exhibit 1: Strategic Asset Allocation Models and Their Suitability to ESG Model Mean–variance optimization (MVO)3 Features Potential link to ESG issues Outputs to reflect ESG issues MVO results in the construction of an efficient frontier that represents a mix of assets that produces the minimum standard deviation (as a proxy for risk) for the maximum level of expected return. It is based on defined asset class buckets and long-term expected returns, risks, and correlations. The Black-Litterman Global Asset Allocation is an MVO model, using the Markowitz portfolio optimization model or modern portfolio theory (MPT). MVO is highly sensitive to baseline assumptions, making it imperative to fully understand any revised assumptions due to ESG considerations. MVO is highly dependent on historical data as the baseline, with adjustments made to reflect future expectations. Volatility as a proxy for risk does not work well in cases of fat tail risk and large market swings. ESG issues could have an impact on assumptions regarding expected return, volatility, and correlation at the asset and sub-asset class level. ESG issues 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. The macroeconomic 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. ESG issues could require a change to baseline factor risk assumptions. Factor risk allocation offers the potential to build in new ESG-related risk factors (such as climate change) to improve diversification (particularly across market risk factors). TPA is relevant to consider ESG issues that require the interplay between judgment about the future and quantitative analysis. TPA requires specialist knowledge to make informed judgments about future risk. TPA’s emphasis on risk budgeting and allocation of capital to opportunities within that budget (bringing alignment between top-down and bottom-up) would provide greater flexibility to capture the potential winners and losers in scenario analysis that also incorporate ESG-related issues. Factor risk allocation4 Factor risk frameworks seek to build a diversified portfolio based on sources of risk. They typically include such factors as fundamental risks (gross domestic product [GDP], interest rates, and inflation) as well as market risks (equity risk premium, illiquidity, and volatility). Total portfolio analysis (TPA)5 Similar to factor risk allocation, TPA allows for closer review and interplay between the strategy setting process and alignment of investment goals. Based on an agreed risk budget, asset allocations are made on expected risk exposures and are less constrained by asset class ‘buckets’ than are traditional MVO approaches. 3 Markowitz, H. 1952. “Portfolio Selection.” Journal of Finance 7 (1): 77–91. Available at: https://doi.org/10.1111/j.1540-6261.1952.tb01525.x Widely-used models to generate the inputs for portfolio optimization (including estimates of asset returns) include Black Litterman (1991) ( www.blacklitterman.org ), with a range of asset return estimation techniques subsequently being developed. 4 For example, see: Idzorek, T. M., and M. Kowara. 2013. “Factor-Based Asset Allocation vs. Asset-Class-Based Asset Allocation.” Financial Analysts Journal 69 (3). Available at: www.cfainstitute.org/research/financial-analysts-journal/2013/factor-based-asset-allocation-vs-asset-class-based-asset -allocation 5 Bass, R., S. Gladstone, and A. Ang. 2017. “Total Portfolio Factor, Not Just Asset, Allocation.” Journal of Portfolio Management Special QES Issue 43 (5): 38–53. Available at: https://media.top1000funds.com/ wp-content/uploads/2017/10/25154404/Total-portfolio-factor-not-just-asset-allocation-2.pdf © CFA Institute. For candidate use only. Not for distribution. Integrating ESG: Strategic Asset Allocation Models Model Features 451 Potential link to ESG issues Outputs to reflect ESG issues Dynamic asset allocation (DAA)6 DAA is driven by changes in risk tolerance, typically induced by cumulative performance relative to investment goals or an approaching investment horizon. DAA could introduce an additional source of estimation errors due to the need for dynamic rebalancing. DAA has the potential to reflect changes in baseline assumptions over different time horizons. Liability driven asset allocation7 Liability driven investment (LDI) seeks to find the most efficient asset class mix driven by a fund’s liabilities. It is simultaneously concerned with the return of the assets, the change in value of the liabilities, and how assets and liabilities interact to determine the overall portfolio value. LDI encounters the same limitations as MVO, with high sensitivity to baseline assumptions. Some ESG issues could potentially impact on inflation and alter liability assumptions. Regime switching models8 Regime switching approaches model abrupt and persistent changes in financial variables due to shifts in regulations, policies, and other secular changes. They capture fat tails, skewness, and time-varying correlations. Regime switching approaches are relevant for considering ESG issues where an abrupt shift is expected over time. They are also typically based more on forward looking rather than historical data. These approaches have the potential to capture dramatic shifts in the investment environment. These models are not yet widely used by investment practitioners. Source: Adapted from Principles for Responsible Investment (PRI).9 Within the asset allocation framework shown in Exhibit 1, one of the most promising approaches may well be the Black–Litterman asset allocation model (BLM). While the Markowitz-derived MVO approach has garnered significant academic support, mean–variance theory poses a number of limitations. For it to function, MVO requires estimates for asset returns across each asset class, which makes the model incredibly sensitive and input-dependent. Any adjustments (even minor ones) to these return estimates will produce a dramatic change in allocation output, so investors may find the model hard to practically implement. By comparison, BLM represents a more intuitive approach. Anchored by the global equilibrium market and not requiring return estimates for each asset class, it can arguably better accommodate areas like pricing climate risk.10 Notwithstanding ESG integration, diversification is a key consideration within any asset allocation framework. Because ESG research has traditionally been equities focused, its relevance has tended to be muted or at best underrepresented within multi- and mixed-asset allocation. As ESG research improves — from 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. 6 For an overview of various dynamic asset allocation techniques, see: Jarvis, S., A. Lawrence, and S. Miao. 2012. “Dynamic Asset Allocation Techniques.” British Actuarial Journal 15 (3): 573–655. 7 For example, see: Hoevenaars, P. M. M., R. D. J. Molenaar, P. C. Schotman, and T. B. M. Steenkamp. 2008. “Strategic Asset Allocation with Liabilities: Beyond Stocks and Bonds.” Journal of Economic Dynamics and Control 32 (9): 2939–2970. 8 Ang, A., A. and Timmerman. 2011. “Regime Changes and Financial Markets.” NBER Working Paper No. 17182. Available at: www.nber.org/papers/w17182 9 PRI. 2019. “Embedding ESG Issues into Strategic Asset Allocation Frameworks.” Discussion paper. Available at: www.unpri.org/embedding-esg-issues-into-strategic-asset-allocation-frameworks -discussion-paper/4815.article 10 For more information, see: Daniel, K. D., R. B., Litterman, and G. Wagner. 2018. “Applying Asset Pricing Theory to Calibrate the Price of Climate Change.” NBER Working Paper No. 22795. Available at: www.nber.org/papers/w22795 452 Chapter 8 © CFA Institute. For candidate use only. Not for distribution. Integrated Portfolio Construction and Management Despite an increasing amount of academic work (see such meta-analyses as those by Friede, Busch, and Bussen)11 supporting ESG’s effect on risk-adjusted returns, introducing ESG into the asset allocation process will undoubtedly carry exposure and weighting implications that must be considered relative to a standard, non-ESG asset mix strategy. In other words, integrating a given ESG methodology (e.g., positive screening that tilts the overall asset mix to a higher-than-mean ESG rating) will introduce some diversification effect or skewness. To be sure, this effect may well be intended. In theory, managing a mixed-asset portfolio according to a carbon constraint or desired exposure level should reduce the risk to a carbon pricing shock through lower commensurate exposure to carbon-intensive, coal-reliant utilities and potential stranded assets. There are trade-offs that investors must consider when allocating to ESG or 'sustainability' more broadly. Portfolio risk can be divided into two portions: 1. the isolated risk of the individual asset or individual investment strategy; and 2. the correlation risk that emerges from the combination of all the assets and strategies. Climate change — and thus climate risk — has emerged as the most material ESG factor for institutional investors to address within asset allocation strategies. Climate risk is both systemic and local. It threatens the financial system and the global means of production as much as it poses risk on a more localized level for specific regions, sectors, and companies. Its potential physical risks will manifest in both acute, event-driven forms (such as extreme weather) and longer-term, chronic shifts driven by the effects of elevated temperatures and rising sea levels. Exhibit 2: Macro-Economic Climate Considerations by Asset Class Asset Classes Equities SAA/ALM Implications Subtypes ► Industries or sectors; ► growth vs. value; ► large, mid, or small cap; and ► long vs. short positions. ► Hedge against inflation, which can result from supply shocks and high government spending; and ► sensitive to growth, macro-economic performance. Climate Change Considerations ► Sensitive to climate impacts on macro-economic performance. 11 Friede, G., T. Busch, and A. Bussen. 2015. “ESG and Financial Performance: Aggregated Evidence from More than 2,000 Empirical Studies.” Journal of Sustainable Finance & Investment 5 (4): 210–233. Available at: https://doi.org/10.1080/20430795.2015.1118917 © CFA Institute. For candidate use only. Not for distribution. Integrating ESG: Strategic Asset Allocation Models Asset Classes Fixed income ► ► Alternative investments SAA/ALM Implications Subtypes Sovereign, municipal, corporate; and ► Sensitive to interest rates; and ► typically less volatile returns. investment vs. non-investment grade (high yield). ► Real estate investment trusts (REITs); ► commodities; ► currencies; ► private equity, venture capital (VC) funds; and ► derivatives, hedge funds. ► ► Attractive for diversification and for low or inverse correlation to market returns; and heterogeneous and wide-ranging risk/return profiles. Climate Change Considerations ► Sensitive to fiscal policy related to climate challenges; ► sensitive to climate-related impacts on issuers’ creditworthiness; and ► many climate impacts fall within the tenor of long-term debt. ► Diversification offered by alternative assets may allow for greater hedging of climate risk; and ► climate risk exposure may be concentrated, opaque, or difficult to assess. Source: Climate Finance Advisors and Ortec Finance (2019).12 It is also clear that climate change represents different risks across asset classes. Accordingly, portfolio managers must recognize that a company’s capital structure will naturally reflect risk. For example, carbon-intensive companies like coal-powered utilities without an adaptation strategy will be at risk in the transition to a low-carbon economy. In such a scenario, equity shareholders (who are subordinate to creditors and bondholders in the capital structure) will be disproportionately impacted. Hence, asset allocation strategies must recognize asset class sensitivity alongside systemic and company-specific risks. 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. What might that look like in an asset allocation context? The asset allocator would work to sensitize the portfolio against different warming scenarios using the 1.5oC (2.7ᵒF) as promoted in the Paris Agreement of 2015 as a baseline.13 Different scenarios should stress test different asset classes across regions, sectors, time periods, and temperature assumptions to understand risks that are now formally characterized as: ► Physical risks. These represent the physical risks manifested by climate change that may impact businesses’ operations, strategy, infrastructure, workforce, or markets; they may carry wider implications across the investment value chain and to the financial system. 12 Climate Finance Advisors and Ortec Finance. 2019. Scenario Analysis for Systemic Climate Risk. Available at: https://climatefinanceadvisors.com/wp-content/uploads/2019/09/310-002-Climate-Risk -Report_V5.pdf 13 Task Force on Climate-related Financial Disclosures. 2019. 2019 Status Report. Available at: www.fsb -tcfd.org/wp-content/uploads/2019/06/2019-TCFD-Status-Report-FINAL-053119.pdf 453 454 Chapter 8 © CFA Institute. For candidate use only. Not for distribution. Integrated Portfolio Construction and Management ► Transition risks. These are the risks represented by legal, regulatory, policy, technology, and market change in the transition to a low carbon economy. Stranded asset risk, for example, would qualify as a transition risk for a portfolio. Investors will inherently be exposed to varying degrees of both physical and transition risks in their investment portfolios. Strategic asset allocation is particularly useful in determining where these risks lie across different asset classes and strategy types over a multi-decade period. Depending on the extent of asset reallocation, some of these choices may require near-term versus long-term trade-offs. For example, reducing (or outright divesting) portfolio concentration to highly carbon-intensive investments in the energy sector will decrease exposure to long-term transition risk. However, this decision may in turn reduce the portfolio income yield as the energy sector is generally associated with an above market cashflow profile and dividend income stream unless capital is redeployed in another sector with similar yield characteristics.14 CASE STUDIES The Path towards Net Zero The urgency to respond to the growing climate crisis is driving both national and corporate commitments towards Paris-aligned net zero carbon emissions targets. Greater emphasis on targets, timetables, and disclosure — particularly with regard to forward-looking data to describe the shape of the transition — is leading to an improved understanding for portfolio management analysis. The following initiatives can be seen to operate as epistemic communities15 as they are vital in developing, advancing, and disseminating methodologies and tools to support efforts to decarbonize and Paris-align portfolios over the next several decades. Paris Aligned Investment Initiative (PAII)16 Launched in 2019 by the Institutional Investors Group on Climate Change (IIGCC), PAII is a European asset owner-coordinated and led initiative working to develop methodologies and assessment tools related to aligning investment portfolios to the Paris Agreement. PAII’s work includes the Net Zero Investment Framework, which defines element of a net zero strategy and offers recommended approaches and actions for investors to take in order to measure and align portfolios towards net zero carbon emissions. Transition Pathway Initiative (TPI)17 Established in 2017, 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. Supporting the transition towards a low-carbon economy, the TPI dataset and 14 Litterman, R. 2015. “David Swensen on the Fossil Fuel Divestment Debate.” Financial Analysts Journal 71 (3): 11. Available at: www.cfainstitute.org/research/financial-analysts-journal/2015/david -swensen-on-the-fossil-fuel-divestment-debate 15 An epistemic community is a network of knowledge-based experts who help decision makers define the problems they face, identify various policy solutions, and assess the policy outcomes. 16 IIGCC. 2021. Paris Aligned Investment Initiative. Available at: www.iigcc.org/our-work/paris-aligned -investment-initiative/ 17 Transition Pathway Initiative (TPI). 2021. The TPI Tool. Available at: www.transitionpathway initiative.org © CFA Institute. For candidate use only. Not for distribution. Integrating ESG: Strategic Asset Allocation Models tool utilize forward-looking carbon metrics to measure and determine companies’ pathways relative to three benchmark scenarios defined by the Paris Agreement. Under TPI, companies are measured in two ways: 1. the quality of companies’ governance and management of their greenhouse gas (GHG) emissions; and 2. carbon emissions relative to international targets and national commitments as defined by the Paris Agreement. Net Zero Asset Owner Alliance18 Launched in 2019, the United Nations-convened Net Zero Asset Owner Alliance is a group of international asset owners who have committed to achieving emissions neutral investment portfolios by 2050 or sooner, supporting global efforts to limit temperature rises to 1.5°C (2.7°F). The Alliance recently finalized its 2025 Target Setting Protocol, which outlines how asset owners calculate and establish climate targets within portfolios and allocate capital towards decarbonization efforts. Net Zero Asset Managers Initiative19 Launched in 2020, the Net Zero Asset Managers Initiative is a group of international asset managers who support the goal of net zero GHG emissions by 2050 or sooner, in line with efforts under the Paris Agreement to limit temperature rises to 1.5°C (2.7°F). Asset manager signatories also commit to support investing aligned with net zero emissions by 2050 or sooner.20 Net Zero Company Benchmark The Net Zero Company Benchmark was developed and launched in 2020 by Climate Action 100+, an investor-led initiative that 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 (strong governance, reduced greenhouse gas emissions, and improved corporate disclosure) and to support investor engagement action.21 It is worth highlighting new literature that introduces the notion of the Inevitable Policy Response (IPR).22 IPR assumes that, in the current environment where the policy response to climate change is inadequate — perhaps best characterized as ‘business as usual’ — governments may potentially respond to increasing climate-borne damage in a sudden reflex reaction. IPR 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. The nature and magnitude of IPR may carry considerable implications for an investment 18 PRI. 2020. UN-Convened Net-Zero Asset Owner Alliance. Available at: www.unpri.org/climate -change/un-convened-net-zero-asset-owner-alliance/5370.article 19 Net Zero Asset Managers Initiative. 2021. Net Zero Asset Managers Initiative. Available at: www. netzeroassetmanagers.org 20 Net Zero Asset Managers Initiative. 2021. Inaugural 2025 Target Setting Protocol. Available at: www.unepfi.org/wordpress/wp-content/uploads/2021/01/Alliance-Target-Setting-Protocol-2021.pdf 21 Climate Action 100+. 2021. Net-Zero Company Benchmark. Available at: www.climateaction100.org/ progress/net-zero-company-benchmark 22 PRI. 2021. What Is the Inevitable Policy Response? Available at: www.unpri.org/inevitable-policy -response/what-is-the-inevitable-policy-response/4787.article 455 456 Chapter 8 © CFA Institute. For candidate use only. Not for distribution. Integrated Portfolio Construction and Management portfolio, particularly in the speed and scope of transition risk. Hence, more sophisticated approaches designed to understand the sensitivity of an investment portfolio to climate policy-related shocks and simulations are warranted as risk measures. Climate-related portfolio analysis is nascent enough that it is worth highlighting the approaches of two practitioners, Mercer and Ortec Finance. Mercer has continued to refine its climate scenario model, now integrating it into a long-term, strategic asset allocation methodology that extends to 2100. Mercer’s report Investing in a Time of Climate Change also addresses the need to enlarge asset allocation models beyond equities. This Mercer report formally extends its climate-informed asset allocation process to sustainability-themed equity, private equity, and real assets, including natural resources and infrastructure. Exhibit 3: Illustrative Approach for Modeling the Investment Impacts of Climate Change Portfolio implementation Identifying areas of risk and opportunity 4 3 2 1 Climate change modelling and literature review Risk factors and scenarios The modelling foundations are provided by a third-party macroeconomic model, E3ME, which draws upon the “GENIE” integrated assessment model (IAM). IAMs combine climate science and economic data to estimate the costs of mitigation, adaptation and physical damages. Three climate change scenarios provide a framework for the relative impacts for identified climate change risk factors over time. Asset sensitivity Portfolio implications The sensitivity to the climate change risk factors is determined for different asset classes and industry sectors. The sensitivity and scenarios are integrated into Mercer’s investment modelling tool to estimate the impact of climate change on investment portfolio returns. Source: Mercer.23 Ortec Finance’s approach integrates climate risks into financial scenarios, which include transition, physical and extreme weather impacts, and pricing dynamics to cover all asset classes. For example, Exhibit 4 illustrates the impact on a representative UK pension fund portfolio over two different investment horizons and against three simulations — Orderly, Disorderly, and Failed — calibrated against the Paris Agreement. 23 Mercer. 2019. Investing in a Time of Climate Change: The Sequel. Available at: www.mercer.com.au/ our-thinking/wealth/climate-change-the-sequel.html © CFA Institute. For candidate use only. Not for distribution. Integrating ESG: Strategic Asset Allocation Models 457 Exhibit 4: Investment Return of a Representative Pension Fund’s Portfolio in Different Climate Pathways and Time Buckets (Stylized Risk–Return Projections) Annual absolute investment return (2020–2024) –3.6% Annual absolute investment return (2025–2029) –3.6% BPO B FT FT 5% VaR 5% VaR PO PD PD –4.5% 0% 5.0% –4.5% 0% 5.0% Average investment return Average investment return B Climate-uninformed baseline (no transition and physical risks assumed) PD Paris Disorderly Transition (limiting warming to below 2oC) PO Paris Orderly Transition (limiting warming to below 2oC) FT Paris Failed Transition (leading to appr. 4oC warming by 2100) Source: Ortec Finance.24 In the nearer-term simulation (2020–2024), climate transition risks point to lower expected investment returns relative to the Paris-aligned pathways (Orderly and Disorderly). While a 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. In the later-term simulation (2025–2029), the average investment return in an orderly transition is similar to the climate-uninformed baseline where transition risk and physical risks are not modeled. In contrast, both the Paris Disorderly and Failed Transitions point to lower expected investment returns. ► ► In the Paris Disorderly Transition pathway, the sentiment shock occurring in 2025 and subsequent increase in volatility remain until 2026. The Paris Failed Transition pathway — characterizing a business-as-usual-scenario that brings about a 4oC (5.4oF) temperature increase by 2100 — leads to diminishing investment returns as the impact of physical risk increases. 24 Ortec Finance. 2019. Scenario Analysis for Systemic Climate Risk: The Case for Assessing the Impacts of Climate Change on Macro-Economic Indicators Used by Institutional Investors. Available at: https://cl imatefinanceadvisors.com/wp-content/uploads/2019/09/310-002-Climate-Risk-Report_V5.pdf 458 Chapter 8 3 © CFA Institute. For candidate use only. Not for distribution. Integrated Portfolio Construction and Management INTEGRATING ESG: ASSET MANAGER SELECTION 8.1.1 explain the impact of ESG factors on strategic asset allocation Within the wider asset allocation process, it is also worth highlighting that allocators are increasingly integrating ESG factors and expectations into their manager selection process. Indeed, the PRI recently published a resource guide for asset owners who allocate to ESG investment managers.25 Allocators range from traditional asset owners, such as pension funds, to fund of funds (FoF) and multi-manager investment strategies. Rather than investing directly into securities and issuers, multi-manager strategies focus on building a platform of strong individual fund managers. These platforms may either focus on internally-managed funds from the same investment firm or funds managed by external managers as well. Due diligence in regard to manager selection combines qualitative and quantitative metrics that, within a framework, track the development, performance, and improvement of managers. Many of the larger multi-manager and fund of funds platforms typically track, monitor, and assess between a hundred and several hundred individual portfolio managers. These multi-manager platforms then review this long list of tracked managers in order to reduce this list to a short list or watch list, ultimately tightening this to a final focus list of managers to allocate capital. In this respect, 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 investment process; ► ownership and stewardship activities; and ► client reporting capabilities. Exhibit 5 depicts an example of a high-level manager selection process, in this case developed by BlackRock Alternative Advisors (BAA). 25 PRI. 2020. Asset Owner Technical Guide – Investment Manager Selection. Available at: https://www.unpri.org/manager-selection/asset-owner-technical-guide-investment-manager-selection-guide/6573.article © CFA Institute. For candidate use only. Not for distribution. Integrating ESG: Asset Manager Selection Exhibit 5: Incorporating ESG into the Manager Selection Process Include ESG questions within its qualitative evaluation of a hedge fund manager during the initial meeting Maintain a view on “best practices” demonstrated by market leaders in the hedge fund space Sourcing Assess key areas of ESG integration as it pertains to a manager’s: – Investment philosophy – Investment strategy – Investment process – Team structure Evaluation Approval 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 Seek to identify market leaders (i.e. managers incorporating ESG considerations in a thoughtful and material way) within each individual hedge fund strategy peer group Include proprietary ESG scoring in the manager tear sheet with review by Manager Approval Group (MAG) Note ESG considerations in due dilligence check list Review ESG policy Ongoing Monitoring Will not invest if the MAG determines that a material and relevant ESG risk cannot be sufficiently understood or qualified Add ESG considerations to BAA’s qualitative heat map Notes: Effective as of January 2020. For illustrative purposes only. Current investment process is subject to change and based on market conditions, managers’ opinions, and other factors. Source: BlackRock Alternative Advisors. As a whole, the due diligence process offers a more nuanced perspective into the degree of ESG integration and the investment approach adopted. A formal monitoring and reporting framework also provides a picture into the progress and evolution of a manager’s ESG capabilities and resourcing. While much of this process naturally focuses on investment facing capabilities, from ESG data integration to dedicated investment strategies, due diligence also commonly assesses operational risk of the investment manager itself. The operational risk portion of manager due diligence may examine what organizational framework and oversight exist at the firm level to support ESG activities at the fund level: ► Has the manager instituted ESG and/or stewardship policies? ► What compliance measures are in place to ensure that exclusion-oriented and/or ESG constraint-based investment mandates and strategies are observed? Furthermore, because of growing regulatory requirements, they may also examine the sophistication of ESG and climate risk reporting. Accordingly, multi-manager and fund of funds platforms are increasingly integrating their own ESG capabilities into more formal scoring frameworks. For some platforms, these frameworks represent a spectrum of capabilities across different 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. Exhibit 6 shows how LGT Capital Partners has tracked the development of ESG capabilities among its managers for seven years, with the data illustrating the progress among the hedge fund managers it monitors. 459 460 Chapter 8 © CFA Institute. For candidate use only. Not for distribution. Integrated Portfolio Construction and Management Exhibit 6: ESG Ratings by the Number of Managers 100% 80% 60% 40% 68% 62% 61% 33% 34% 82% 54% 42% 22% 20% 5% 0% 82% 75% 4% 2013 2014 5% 2015 1 + 2 – Excellent & Good 16% 10% 9% 9% 2017 2016 3 – Fair 2018 15% 3% 2019 4 – Poor Source: LGT Capital Partners (2020).26 Exhibit 7 illustrates an example of a more complex fund of funds manager’s approach, assessing the ESG capabilities among its underlying alternative managers. This stylized ranking summarizes due diligence performance at the operational (firm) level and at the investment (fund) level. What makes this exercise difficult is that it seeks to understand and score ESG capabilities across a range of strategy types, including arbitrage, credit, long/short, and macro investing. As we will later discuss, the nature of the underlying instruments or investment horizon or timeframe mean that ESG is more relevant and easily-applied for some portfolios than other strategies. The assessment also normalizes for firm size across funds, as smaller firms are generally less resourced and less able to absorb the financial costs of ESG compliance, research, data, and personnel requirements. 26 LGT Capital Partners. 2020. ESG Report 2019. Available at: www.lgtcp.com/shared/.content/ publikationen/cp/esg_download/LGT-CP-ESG-Report-2019_en.pdf © CFA Institute. For candidate use only. Not for distribution. Approaches to Integrating ESG: Portfolio Level Framework 461 Exhibit 7: Assessing ESG Capabilities among a Platform of Alternative Managers Improvement needed Meets expectations Exceeds expectations 1,000 Manager D Manager K Manager headcount Manager H 100 Manager G Manager J Manager L Manager B Manager E Manager F Manager A 10 1 0% Manager C Manager I 10% 20% 30% 40% Arbitrage 50% RI Score Credit 60% 70% Long short Macro 80% 90% 100% Source: Man FRM (2021).27 APPROACHES TO INTEGRATING ESG: PORTFOLIO LEVEL FRAMEWORK 8.1.2 describe approaches for integrating ESG into the portfolio management process 8.1.3 explain approaches for how internal and external ESG research and analysis is used by portfolio managers to make investment decisions As earlier chapters demonstrate, there is a rich diversity of approaches for integrating ESG at the individual securities level. This heterogeneity is now carrying over to portfolio construction and management, where new methodologies and frameworks are leveraging ESG datasets with innovations that drive fundamental and quantitative, as well as active and passive, investment strategies. The endgame for ESG integration at the portfolio level is the 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. In this respect, ESG integration within portfolio management requires a different manner of explanatory power than integration at the individual security level: It should embed ESG considerations into: ► the highest level, asset allocation decisions; 27 Man Group. 2021. The Wheat from the Chaff – A Guide to Rating an RI Fund Manager. Available at: www.man.com/maninstitute/wheat-and-chaff 4 462 Chapter 8 © CFA Institute. For candidate use only. Not for distribution. Integrated Portfolio Construction and Management ► portfolio exposure to non-financial factors; ► risk management measures; and ► performance attribution. Statistics published by the PRI are often used to frame investor activities in ESG integration. But what do these statistics really reveal about ESG integration at the portfolio level?28 Data compiled by Mercer Consulting (see Exhibit 8), one of the largest global institutional investment advisers, suggests that progress in ESG integration is marked by a high degree of variation depending on asset class and investment strategy type. What is perhaps more interesting, though, is that these data reinforce the notion that integration is broadly more advanced across managers despite being slower to manifest itself through formal- and dedicated sustainability-themed strategies. Exhibit 8: Mercer Consulting’s View on ESG Integration and Availability of Strategies by Asset Class Asset Class Manager Progress on ESG Integration* Availability of Sustainability-Themed Strategies** Public equity (active) Medium/high Low/medium Fixed income Low/medium Low Real estate Medium/high Low Private equity and debt Infrastructure Natural resources*** Hedge funds Medium Low/medium High Medium/high Medium Medium/high Low Low Explanatory notes: * Refers to the percent distribution of ESG1- and ESG2-rated strategies in the Mercer Global Investment Manager Database (GIMD), where available. ** Refers to the percent distribution of sustainability-themed strategies compared to the asset class universe — noting equities is a large universe, so the low relative number is not actually a low absolute number. *** Conservative view – research updates in this asset class may result in a more favorable view than is currently held. ► ► ► ► ► Low: below 5% Low/medium: 5% to 10% Medium: 11% to 20% Medium/high: 21% to 40% High: above 40% (as of December 2018) Source: Mercer.29 What Exhibit 8 does not illustrate, though, is the breadth and diversity of approaches within each of these categories. Earlier chapters have discussed some of these ESG methodologies as applied to individual securities. Examining these at the portfolio level draws important distinctions and also highlights the challenges that many approaches face in the path towards a credible form of ESG integration. 28 PRI. 2020. About the PRI. Available at: www.unpri.org/pri/about-the-pri 29 PRI. 2021. What Is the Inevitable Policy Response? Available at: www.unpri.org/inevitable-policy -response/what-is-the-inevitable-policy-response/4787.article © CFA Institute. For candidate use only. Not for distribution. Approaches to Integrating ESG: Portfolio Level Framework This ESG process is detailed in Chapter 7. It is worth revisiting the CFA Institute ESG integration framework (see Exhibit 9). This forms the foundation of integration. More importantly, it demonstrates the expanding, sequenced degrees of analysis at different levels. At its core, the framework represents the process of ‘classical ESG research and analysis,’ which focuses on the individual security level. The framework then expands outward, assuming more layers of analysis across a greater number of dimensions — including asset classes and investment strategy types — within portfolio and ultimately asset allocation decision making. 463 464 © CFA Institute. For candidate use only. Not for distribution. Integrated Portfolio Construction and Management Chapter 8 IO AR SIS LY A AN RI SK ESG and financial risk exposures and limits Portfolio scenario analysis Forecasted financials & ratios Internal credit assessment E COM D IN IXE —F ON TI UA AL SE CU RI TY V RESEARCH ESG-integrated research note Forecasted financial ratios SECURITY Tactical asset allocation Valuation multiples Relative ranking Centralised research dashboard ESG agenda at (committee) meetings Materiality framework ESG INTEGRATION SWOT analysis O ATI VALU ASSE Watch lists N— T AL Red-flag indicators EQ UI LOC TI Duration analysis ESG profile (vs. benchmark) ES IO AT Valuation-model variables Company questionnaires Value-at-risk analysis Relative value analysis/ spread analysis Voting Individual/ collaborative/policy engagement Internal ESG research MA N T EN EM AG SC EN Exhibit 9: ESG Integration Framework E Q UI TI E S/ F IXE Security level E PO Portfolio weightings Research level UC TIO M CO D IN NS TR Security sensitivity/ scenario analysis N N Strategic asset allocation Forecasted financials F RT I OL O CO Portfolio level Source: CFA Institute (2018) in collaboration with PRI.30 It is important to emphasize that this illustration of ESG integration depicts roles that are distinct from one another, just as the role of portfolio manager is distinct from that of an investment research analyst. 30 CFA Institute and PRI. 2018. Guidance and Case Studies for ESG Integration: Equities and Fixed Income. Available at: www.unpri.org/investor-tools/guidance-and-case-studies-for-esg-integration -equities-and-fixed-income/3622.article © CFA Institute. For candidate use only. Not for distribution. Approaches to Integrating ESG: Role of Analysts, Portfolio Managers, and Internal and External Research APPROACHES TO INTEGRATING ESG: ROLE OF ANALYSTS, PORTFOLIO MANAGERS, AND INTERNAL AND EXTERNAL RESEARCH 8.1.2 describe approaches for integrating ESG into the portfolio management process 8.1.3 explain approaches for how internal and external ESG research and analysis is used by portfolio managers to make investment decisions Role of Analysts Analysts (particularly fundamental analysts) present and justify their views in ‘a story’ or ‘investment thesis’ of a security, which generally entails incorporating different factors. These factors often include: ► the intrinsic value of the security; ► credit analysis; ► the potential for a re-rating or de-rating in valuation; ► potential risks; ► short-term and long-term catalysts; and ► an expectation on the security’s earnings growth and cash flow profile. ESG is an increasingly recognized element within securities analysis and, if material enough, may likely carry meaningful implications that help the investment thesis. Role of Portfolio Managers 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 for a given security, their primary role is to weigh security-specific conviction against: ► macro- and micro-economic data; ► portfolio financial and non-financial exposure; and ► sensitivities to potential shocks. The treatment of ESG in a portfolio context — if properly and systematically integrated, regardless of whether in active or passive portfolio management — should be considered in the same light as these other factors. The challenge that portfolio managers face is how to widen the focus of research and datasets largely optimized for security analysis into tools that can better inform portfolio and asset allocation analysis and decision making, 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: ► the organizing principles and methodologies for ESG analysis; 5 465 466 Chapter 8 © CFA Institute. For candidate use only. Not for distribution. Integrated Portfolio Construction and Management ► 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. In addition, ESG integration should be considered in light of two different investment strategies: ► ► Discretionary ESG investment strategies most commonly take the form of a fundamental portfolio approach. A portfolio manager would work to complement bottom-up financial analysis alongside the consideration of ESG factors to reinforce the investment thesis of a particular holding. The portfolio manager would then work to understand the aggregate risk at the portfolio level across all factors to understand correlation and event risks and potential shocks to the portfolio. Quantitative investment strategies are, broadly speaking, rules-based approaches employing the statistical application of financial and/or non-financial factors to drive securities selection. Quantitative strategies generally seek to minimize the higher costs associated with discretionary active management. Where discretionary strategies often focus on depth within a portfolio, manifested through a portfolio of few, more concentrated holdings, quantitative strategies focus on breadth, using a much larger portfolio of holdings to target risk and volatility-adjusted returns. Approaches may assume several forms when integrating ESG. Traditionally, passive or index-based strategies have been the most popular investment vehicles. These impose a custom index, typically with exclusion criteria. However, quantitative approaches are now becoming more sophisticated and rigorous when integrated into ESG, from beta-plus funds to single and multi-factor ESG models. ESG integration can focus on risks as well as opportunities. A bias towards either of these can lead to different return profiles at the portfolio level as the emphasis can shift from downside protection to upside participation. Developing a Policy that Reflects ESG-Integrated Portfolio Management As a matter of definition — to the market, clients, and stakeholders — an ESG policy should formally outline the investment approach and degree of ESG integration within a firm. Particularly, asset managers should have ESG policies for asset classes and the approach used. The PRI provides guidance and templates to develop ESG policies. There are well-established resources for developing a comprehensive ESG policy, though these have traditionally catered to the long-only equities and fixed-income strategies.31 It is worth noting that investor organizations are now addressing policy development in alternative investment areas, including hedge funds.32 Further information on how ESG can be embedded in investment mandates and ESG policy can be found in Chapter 9. 31 PRI. 2018. An Introduction to Responsible Investment: Policy, Structure and Process. Available at: www.unpri.org/pri/an-introduction-to-responsible-investment/policy-structure-and-process 32 AIMA. 2021. Responsible Investment. Available at: www.aima.org/regulation/responsible-investment.html © CFA Institute. For candidate use only. Not for distribution. Approaches to Integrating ESG: Role of Analysts, Portfolio Managers, and Internal and External Research 467 Complementing Internal Research with External ESG Resources Broadly speaking, ESG external research and analysis can be categorized between academic research and practitioner research. Each of these resources offers their own unique advantages and disadvantages for investors. While meta-analyses surveying more than 2,000 academic studies indicate an overall positive bias in the linkage between ESG and investment returns (see Exhibit 10), academic studies on an individual basis often end up disconnected from practice and are not widely or generally applicable. While certainly additive to the overall discussion, these are often unhelpful for practitioners who tend to search for cross-regional and cross-temporal factors or frameworks that can be universally or generally applied to portfolios. 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. As the ESG industry matures, institutional investors are finding an increasingly diverse universe of external research resources. These resources now include not only ESG-specific research content but also new quantitative techniques, such as natural language processing, machine learning, and even artificial intelligence to organize ESG data. Indeed, the market for ESG content and indexes is expected to grow from USD300 million (GBP216 mn) in 2016 to almost USD1 billion (GBP0.7 bn) by 2021.33 These resources complement internal investment research as well as provide internal quantitative and performance analytics teams the opportunity to refine methodologies for managing ESG risk. Just as external providers are innovating ESG datasets and producing research, so too are investors developing in-house capabilities to differentiate themselves across asset classes and investment strategy types. Exhibit 10: Academic vs. Practitioner Research Making ESG-Linked Performance Claims Academic survey and meta-analyses (evidence from >2,000 empirical studies) Practitioner example study of ESG-rating based performance relative to MSCI Europe 125 62.6% 120 Vote-count studies 47.9% Meta-analyses 115 110 105 100 95 90 0.146 6.9% Share of positive findings 0.15 8.0% Share of negative Weighted correlation findings in level r in studies 85 80 75 2012 2013 2014 2015 AAA BB Source: MSCI ESG Research, FactSet, and Nordea Markets (2018).34 33 Pierron, A. 2020. ESG Data Market: No Stopping Its Rise Now. Opimas. Available at: www.opimas.com/research/548/detail/ 34 MSCI ESG Research, FactSet, and Nordea Markets. 2018. Research Insights: ESG. Available at: https://nordeamarkets.com/wp-content/uploads/2018/09/ESG_140918.pdf 2016 2017 AA B & CCC A 2018 2019 BBB 468 Chapter 8 © CFA Institute. For candidate use only. Not for distribution. Integrated Portfolio Construction and Management For most investors, the sheer breadth and diversity of external ESG research represents a difficult resource to replicate by internal research analysts. While research (such as ESG ratings from third-party data providers) comes at a cost, many of these other resources are freely available. The list of practitioner resources, though by no means exhaustive, includes: ► 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 organizations (NGOs) research; ► governmental agencies and central banks; and ► multilateral institutions and agencies. Given the wide array of research resources available, portfolio managers should reflect on their research requirements. The profundity of research, from ESG integration at the individual security level to the portfolio level, continues to mature and provide investors with several ways to assess and report exposure. In fact, it is important to note that this spectrum ranges from reporting a static or backwards-looking picture of a portfolio’s position-weighted ESG rating towards a more advanced quantification of underlying ESG risk and exposure in the manner applied by traditional quantitative finance measures. Recommendations by the TCFD provide an important model for both a move towards ESG standards convergence and in elevating risk exposure metrics to the portfolio level from the underlying asset level. Where carbon intensity was previously determined in the form of carbon footprint on a per company or per asset basis, for example, portfolio managers may now treat carbon exposure on a portfolio-weighted basis. Weighted-average carbon intensity measures a portfolio’s exposure to carbon-intensive companies on a position-weighted carbon exposure. Calculated as the carbon intensity (Scope 1 + 2 Emissions ÷ USD 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. It is important to note that TCFD is a principles-based framework providing recommendations for assessing climate risk and exposure. Because TCFD is not prescriptive, different approaches to measure carbon intensity have developed. For example, while the European Union’s (EU) Sustainable Finance Disclosure Regulation (SFDR) accounts for Scopes 1, 2, and 3 emissions, UK TCFD practice currently focuses on only Scope 1 and Scope 2 emissions. Scope 3 emissions, which represent indirect emissions that occur within a company’s value chain, are particularly difficult to measure because of the potential lack of data, transparency, and disclosure within layers of a supply chain. As data and supply chain visibility improve, it is expected that emissions analysis will normalize to cover Scope 1, 2, and 3. © CFA Institute. For candidate use only. Not for distribution. Approaches to Integrating ESG: Role of Analysts, Portfolio Managers, and Internal and External Research Exhibit 11: Weighted-Average Carbon Intensity at the Portfolio Level i ________________________________i ____________________ ∑(           ) current portfolio value ×      issuer's US$m revenue i n current value of investment issuer's Scope 1 and Scope 2 GHG emissions i Source: Implementing the Recommendations of the TCFD.35 Investors should recognize the need to differentiate themselves irrespective of their approach to ESG integration. Asset owners continue to rebase their expectations for the quality of proprietary ESG research that asset managers and consultants can provide to them. In turn, investors complement external, off-the-shelf research and data analytics with internal, proprietary ESG research. One of the less developed areas where investors are able to both innovate and differentiate themselves is in the demonstration of how ESG is embedded in their portfolio construction and management process. In this respect, the Sustainability Accounting Standards Board (SASB) has much to offer as their framework and materiality map spans issuer-specific materiality as well as overall portfolio exposure. Covering equities, fixed income, private equity, and real assets, SASB’s Materiality Map is capable of assessing portfolio exposure to sustainability risks and opportunities across each issue.36 Another development is SASB work around the Sustainable Industry Classification System (SICS). Modeled after the Global Industry Classification Standard (GICS), SICS offers an improved industry classification standard that speaks directly to ESG materiality. The SICS system organizes companies according to their sustainability attributes, such as resource intensity, sustainability risks, and innovation opportunities.37 For more on SASB’s materiality map, see Chapter 7. The starting point that many portfolio managers employ is to upload their portfolios onto third-party ESG data provider online platforms. While these platforms vary in sophistication, they do offer the first composite picture of a portfolio’s stock-specific risks on a number of potential ESG metrics. Many of these platforms are capable of: ► illustrating a portfolio’s mean exposure and weighting towards low-, mid-, or high-scoring companies on ESG metrics; ► producing a picture of the portfolio’s environmental and carbon exposure on an absolute-value basis, for instance, expressed as weighted-average carbon intensity; and ► approximating an overall controversy or risk score for the portfolio. Asset owners and managers increasingly recognize the limitations of third-party ESG platforms and the need to develop more sophisticated ESG analytics platforms that combine third-party and proprietary capabilities. The rationale stems not only from the interest in safeguarding portfolio holdings — particularly with regard to clients’ segregated investment mandates — but also in demonstrating a differentiated approach to understanding and reporting portfolio data. Given the subjectivity and divergence among ESG ratings providers, developing an approach that incorporates both third party and proprietary ESG data lowers an overreliance on a single provider and creates greater context for discussion when reviewing the risk profile of a portfolio. 35 Task Force on Climate-related Financial Disclosures. 2017. Implementing the Recommendations of the Task Force on Climate-related Financial Disclosures. Available at: www.fsb-tcfd.org/wp-content/ uploads/2017/12/FINAL-TCFD-Annex-Amended-121517.pdf 36 Sustainability Accounting Standards Board (SASB). 2018. SASB Materiality Map. Available at: https://materiality.sasb.org/ 37 Nascimento, D., and S. Payal. 2018. “Industry Classification & Environmental, Social and Governance (ESG) Standards” (September). Available at: www.norburypartners.com/industry -classification-esg-standards 469 470 Chapter 8 © CFA Institute. For candidate use only. Not for distribution. Integrated Portfolio Construction and Management For example, a portfolio ESG analytics tool employed by an asset manager may aggregate a number of different data streams from ESG providers to produce a picture of ‘consensus,’ rankings-oriented ESG scores and their variance alongside an internally-produced ‘proprietary’ ESG score, in addition to a view of absolute values-based environmental fund metrics and exposures. These analytics tools enable investment teams to decompose both their portfolios and benchmark indexes, sort by ratings, and understand the distribution curves across a number of ESG metrics. They often provide drill-down capabilities that illustrate a more detailed picture of ESG characteristics on an underlying basis for positions. 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. This exercise is no different to how current portfolio tools provide the means to stress test portfolios against simulations, such as interest rate or oil shocks. 6 APPROACHES TO INTEGRATING ESG: QUANTITATIVE RESEARCH DEVELOPMENTS IN ESG INVESTING 8.1.2 describe approaches for integrating ESG into the portfolio management process 8.1.3 explain approaches for how internal and external ESG research and analysis is used by portfolio managers to make investment decisions One of the most exciting areas of research development in portfolio management focuses on quantitatively understanding the risk properties of ESG. As Chapter 7 notes on the challenges to ESG integration at the individual security level, there is widespread disagreement about what an ESG factor represents. The fundamental manager’s focus on bottom-up research elevates the ESG integration process as the primary means to drive price discovery, or understand the value of an asset or security. This process is often described in case study form. Generally speaking, these case studies illustrate the long-term price appreciation of an issuer against the portfolio’s investment position to demonstrate the investor’s long-term holding period. Moreover, they are often annotated by interactions and engagements with the issuer’s management as evidence that ESG integration is contributing to the fund’s investment returns. But while single-security case studies often frame the investment process with a powerful engagement story, their anecdotal nature does not describe performance attribution from ESG exposure at a portfolio level. Portfolio analytics typically provide performance analytics that describe regional, sectoral, and stock-specific performance attribution over a given time period. In the same way, the assumption or contention that ESG is alpha generating in its own right must also be tested on the same attributional basis. Hence, it is worth reflecting briefly on ESG research, ESG ratings and scores, and the signal or input they provide for active and passive strategies. Describing ESG performance attribution at a portfolio level requires quantifying ESG as a factor or risk premium in its own right. Third-party data providers are developing increasingly sophisticated ESG ratings and scoring methodologies, but many fall short in describing ESG as an uncorrelated, statistically independent factor. In fact, the ratings from many providers reveal a significant, underlying correlation to existing factors, such © CFA Institute. For candidate use only. Not for distribution. Approaches to Integrating ESG: Quantitative Research Developments in ESG Investing 471 as value, quality, size, and momentum. In one respect, this should not be surprising. Transparency bias generally accrues to larger, more mature companies with higher ESG ratings. Nonetheless, the correlation to other factors effectively undermines the effort to define ESG as uniquely singular enough to be included in risk factor attribution analyses. One of the most popular areas for research is the development and application of ESG ratings and scoring in the context of portfolio construction and management. In fact, the influence of ESG ratings within the investment community should not be underestimated, and its growing popularity presents a combination of positives and negatives that investors should consider. Supported by a growing number of academic and practitioner studies that demonstrate a correlation between corporate ESG operational metrics and financial returns, many investors have embraced ESG scoring methodologies. In turn, ESG rating and scoring methodologies are evolving as institutionalized features both in retail and institutional investor platforms. For example, Morningstar, the popular investment and research platform catering to both retail and institutional investors, first introduced its sustainability rating to complement its core fund rating in 2016.38 Updated in 2019 to incorporate the new Sustainalytics company-level ESG Risk Rating, the Morningstar methodology now reflects a company’s ESG risks measured on the same scale across industries, and the overall fund rating shows the ESG risk embedded in the fund’s portfolio. For more on the Sustainalytics and Morningstar risk ratings, see Appendix to Chapter 7. Exhibit 12: ESG Rating Correlation among Six Third-Party Data Providers Pearson Correlations N (1) Mean (2) Median (3) Standard deviation (4) Asset4 31424 0.501 0.501 0.289 Sustainalytics 32703 0.501 0.499 0.289 0.762 Inrate 25945 0.501 0.534 0.284 0.233 0.303 Bloomberg 32410 0.501 0.501 0.289 0.749 0.708 0.122 KLD 32485 0.501 0.507 0.288 0.584 0.619 0.29 0.538 MSCI IVA 32450 0.501 0.502 0.289 0.418 0.46 0.319 0.308 Asset4(5) Sust. (6) Inrate (7) FTSE (8) KLD (9) Panel A: Total rating Average correlation 0.452 0.458 Panel B: Environmental pillar Asset4 31261 0.501 0.501 0.289 Sustainalytics 32532 0.501 0.501 0.289 0.71 Inrate 25880 0.501 0.518 0.286 0.305 0.488 Bloomberg 28258 0.501 0.501 0.289 0.651 0.566 0.206 KLD 32403 0.501 0.498 0.281 0.629 0.654 0.422 0.472 MSCI IVA 32361 0.501 0.502 0.289 0.174 0.325 0.403 0.14 38 Morningstar. 2016. The Morningstar Sustainability Rating. Available at: www.morningstar.co.uk/uk/ news/148119/the-morningstar-sustainability-rating.aspx 0.284 472 © CFA Institute. For candidate use only. Not for distribution. Integrated Portfolio Construction and Management Chapter 8 Pearson Correlations N (1) Mean (2) Median (3) Standard deviation (4) Asset4(5) Sust. (6) Inrate (7) Average correlation FTSE (8) KLD (9) 0.429 Panel C: Social pillar Asset4 31424 0.501 0.501 0.289 Sustainalytics 32703 0.501 0.504 0.289 0.617 Inrate 25945 0.501 0.522 0.288 0.133 0.143 Bloomberg 32322 0.501 0.507 0.288 0.682 0.53 0.061 KLD 32485 0.501 0.505 0.288 0.397 0.423 0.128 0.302 MSCI IVA 32450 0.501 0.5 0.289 0.282 0.323 0.236 0.207 Average correlation 0.351 0.321 Panel D: Governance pillar Asset4 31424 0.501 0.501 0.289 Sustainalytics 32703 0.501 0.504 0.289 0.312 Inrate 25945 0.501 0.502 0.283 0.297 0.401 Bloomberg 32410 0.501 0.487 0.283 0.421 0.34 0.343 KLD 32485 0.501 0.489 0.237 0.059 0.034 0.083 0.095 MSCI IVA 32450 0.501 0.501 0.288 0.141 0.129 0.144 0.045 Average correlation 0.152 0.2 Source: Brandon, Krueger, and Schmidt.39 Readers may ask what common risk factors explain ESG ratings. One means of answering this question is to examine the underlying factor exposure of the highest-rated ESG companies versus the lowest-rated companies. This exercise reveals that what is purportedly marketed as an ‘ESG signal’ with quasi-predictive signaling power is instead driven largely by existing factors. 39 Brandon, R. G., P. Krueger, and P. S. Schmidt. 2021. “ESG Rating Disagreement and Stock Returns.” Financial Analysts Journal 77 (4). Available at: https://www.cfainstitute.org/en/research/financial -analysts-journal/2021/1963186 © CFA Institute. For candidate use only. Not for distribution. Approaches to Integrating ESG: Quantitative Research Developments in ESG Investing Exhibit 13: Underlying Factor Exposure among Existing Third-Party Data Providers (Arabesque S-Ray and RepRisk ESG) MSCI ESG 1.0 0.8 0.6 Size Growth Price / earnings Value 0.4 0.2 0.0 -0.2 Price / book Return on equity Quality Price momentum -0.4 -0.6 Momentum Low volatility Arabesque S-Ray RepRisk ESG Source: J.P. Morgan, Arabesque, and RepRisk ESG.40 Exhibit 14: Underlying Factor Exposure among Existing Third-Party Data Providers (Sustainalytics and MSCI) 1.2 1.0 0.8 Yield 0.6 Value 0.4 0.2 Liquidity Beta 0.0 Size -0.2 Momentum -0.4 -0.6 -0.8 Specific risk Sustainalytics MSCI Source: Man Numeric, Sustainalytics, and MSCI.41 This represents, in effect, a causality problem for ESG. In other words: ► What exactly is ESG? ► If it can be quantified or measured, is it simply an amalgam of other established factors, like size and quality? 40 J.P. Morgan. 2016. ESG – Environmental, Social and Governance Investing: A Quantitative Perspective of How ESG Can Enhance Your Portfolio. Available at: https://yoursri.com/media-new/ download/jpm-esg-how-esg-can-enhance-your-portfolio.pdf 41 Man Numeric, MSCI, and Sustainalytics. 2019. ESG Data: Building a Solid Foundation. Available at: www.man.com/maninstitute/esg-data-building-a-solid-foundation 473 474 Chapter 8 © CFA Institute. For candidate use only. Not for distribution. Integrated Portfolio Construction and Management The practitioner argument for causality is that a transparency bias towards large companies favors 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. The linkage between quality and ESG as factors stems from the intuition that the governance of higher ESG-rated companies drives stronger decision making around capital allocation and shareholder returns. If ESG does not represent a mix of existing factors like quality and value, then how can academics and practitioners begin to define it in its own right — as an uncorrelated factor? This is a fundamental question for investors because the potential development of ESG as an uncorrelated factor opens up powerful significant opportunities to better embed it within portfolio management. 7 THE EVOLUTION OF ESG INTEGRATION: EXCLUSIONARY PREFERENCES AND THEIR APPLICATION 8.1.4 explain the different approaches to screening and the benefits and limitations of the main approaches 8.1.5 explain the main indexes and benchmarking approaches applicable to sustainable and ESG investing, noting potential limitations Screening represents the oldest, simplest approach to ESG investing. Negative screening imposes a set of exclusions based on ethical preferences or around a normative worldview to shape the investable universe of a portfolio. Indeed, its first formal use was aligned to religious values, when the Methodists avoided investing in businesses that dealt in alcohol, tobacco, and gambling. In the 18th century, the Quakers aligned their investment approach to their stance against slavery, choosing to screen out investments and boycott business interests that supported the slave trade. In a similar manner, Islamic approaches to investment apply hard or soft interpretations of Shariah principles to filter out companies that are not Shariah-compliant.42 Many investors apply exclusions to restrict exposure to certain sectors or securities that conflict with their worldview. Exclusions typically take the form of sectors or industries commonly known as ‘sin sectors’ that include tobacco, pornography, gaming, and alcohol. But exclusions can just as easily target specific companies or even countries. Exclusions have traditionally represented ethical and normative restrictions. For example, a church pension plan may exclude gambling, alcohol, and pornography while a pension fund that represents healthcare workers may exclude investment in the tobacco sector. According to statistics maintained by the Global Sustainable Investment Alliance (GSIA), exclusions-based approaches remain the largest portion of dedicated, ESG-screened assets under management (AUM).43 Their size and growth points to 42 Shariah-compliant investment funds are a type of responsible investment governed by Islamic law. Like other faith-based screening approaches, Shariah-compliant funds operate on exclusionary screening that typically excludes: conventional banking and insurance; pork and non-Halal foods; alcohol; gambling; tobacco; adult entertainment; synthetic instruments like derivatives and swaps; and weapons. The Shariah Supervisory Board applies and arbitrates exclusionary criteria. 43 For a detailed breakdown, please see: GSIA. 2018. 2018 Global Sustainable Investment Review. Available at: www.gsi-alliance.org/wp-content/uploads/2019/06/GSIR_Review2018F.pdf © CFA Institute. For candidate use only. Not for distribution. The Evolution of ESG Integration: Exclusionary Preferences and Their Application the expansion from traditional areas of exclusion, such as controversial arms and munitions, into other areas, such as tobacco, thermal, coal, and nuclear weapons. Because of their subjective nature and their regional, faith-based and normative specificity, exclusions are often treated as irreconcilable. For instance, it would be rare to find two pension funds with perfectly overlapping worldviews and normative expectations. Nonetheless, it is possible to organize exclusions across four basic categories: 1. universal; 2. conduct-related; 3. faith-based; and 4. idiosyncratic exclusions. Universal Exclusions Universal exclusions represent exclusions supported by global norms and conventions, like those from the United Nations (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. EXAMPLE 1 Arms and Munitions and Tobacco Exclusions Arms and Munitions Exclusions Exclusions governing investment in controversial arms and munitions are supported by multilateral treaties, conventions, and national legislation. ► ► ► ► ► ► ► Ottawa Treaty (1997) prohibits the use, stockpiling, production, and transfer of anti-personnel mines. UN Convention on Cluster Munitions (2008) prohibits the use, stockpiling, production, and transfer of cluster munitions. UN Chemical Weapons Convention (1997) prohibits the use, stockpiling, production, and transfer of chemical weapons. UN Biological Weapons Convention (1975) prohibits the use, stockpiling, production, and transfer of biological weapons. Treaty on the Non-Proliferation of Nuclear Weapons (1968) limits the spread of nuclear weapons to the group of so-called Nuclear-Weapons States (USA, Russia, UK, France, and China). Belgium (2009) bans investments in depleted uranium weapons. UN Global Compact announced the decision (2017) to exclude controversial weapons sectors from participating in the initiative. 475 476 Chapter 8 © CFA Institute. For candidate use only. Not for distribution. Integrated Portfolio Construction and Management Tobacco Exclusions Although tobacco does not exhibit the same degree of universal acceptance that the exclusion over controversial arms and munitions does, it provides another example that can be said to be supported by the following: ► ► ► WHO Framework Convention (2003) on Tobacco Control, with 181 parties committing to implementing a broad range of tobacco control measures. UN Global Compact (UNGC) announced the decision (2017) to exclude tobacco companies from participating in the initiative as tobacco products are fundamentally misaligned with UNGC’s commitment to advancing business action towards Sustainable Development Goal (SDG) 3 and are in direct conflict with the right to public health. UN SDGs (2015) drive a collection of 17 global goals to eradicate poverty, protect the planet, and improve prosperity; many of the goals touch on tobacco as an impediment to improved social and environmental outcomes. Conduct-Related Exclusions Conduct-related exclusions are generally company or country-specific and often not a statement against the nature of the business itself. Labor infractions in the form of violations against the International Labour Organization (ILO) principles are often cited. Faith-Based Exclusions Faith-based exclusions are specific to religious institutional or individual investors. For more on faith-based exclusions, see Chapter 1. Idiosyncratic Exclusions Idiosyncratic exclusions are 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.44 Applying Exclusionary Preferences 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. This is often because of their global reach and the subjective nature of negative screens. Hence, pooled or commingled investments and listed funds (such as undertakings for the collective investment in transferable securities [UCITS] funds) generally do not have exclusionary screens implemented, unless noted within their investment mandate. That said, asset managers do manage dedicated mandates for asset owners that commonly impose some form of an exclusionary screen. 44 NZ SuperFund. 2019. Exclusions. Available at: https://nzsuperfund.nz/how-we-invest-responsible -investment/exclusions © CFA Institute. For candidate use only. Not for distribution. The Evolution of ESG Integration: Exclusionary Preferences and Their Application Among global asset owners, Norges Bank, in its Norwegian sovereign wealth fund (SWF), constructs and implements the most visible of these asset owner exclusion lists. Because of the size of its AUM, Norges Bank’s exclusion list has been adopted by other Norwegian asset owners and continues to influence the construction of exclusions lists among other Nordic asset owners.45 Because of its relative ease of implementation, screening is the most universal approach within ESG investing. While the simplicity of exclusions means that they are often widely applied in both traditional asset classes as well as private markets and alternatives, the extent of exclusions may carry implications for a portfolio. It is important to highlight that some issues continue to remain difficult to reconcile from a screening perspective, which means that investors often assume a best efforts approach in these cases. The degree of exclusions may carry significant implications from a portfolio management perspective, not just in terms of higher tracking error and active share, but also unintended factor exposure. Tracking error and active share are measures that represent the degree to which a portfolio deviates from its benchmark. A portfolio that imposes a broad set of exclusions (particularly sector exclusions, which represent a significant weight of their benchmark), will likely produce high active share and tracking error. This magnitude of difference may lead the portfolio manager to adopt a more appropriate ESG benchmark rather than a broad market benchmark. On the other hand, a portfolio that applies a narrow exclusion list that doesn’t by itself produce higher active share or tracking error may leave the benchmark index unchanged unless the exclusions represent a meaningful change to the risk–return profile to the investment fund. In addition, the list of excluded companies may not apply to index derivatives or proprietary index construction. This compromise is generally done to reflect the burden of repeatedly decomposing indexes. In some cases — particularly for smaller, more obscure indexes — investors make this compromise because of the prohibitive cost of purchasing the underlying constituent weights.46 EXERCISE Construct an equities-only portfolio that aligns with your worldview. Consult the Global Industry Classification Standard (GICS)47 to view its hierarchy of 11 sectors and underlying 24 industry groups. Discuss your construction: ► What sectors would you exclude? Are these normative (universally supported) or more idiosyncratic? ► How do your choices change the size of your investable universe? ► What implications would your chosen exclusions have for the overall portfolio’s exposure? ► Would they make the portfolio more pro-cyclical or more defensive? ► How would it change its yield profile? What ways could you compensate for the effects of your exclusions? 45 Norges Bank. 2019. Observation and Exclusion of Companies. Available at: www.nbim.no/en/the -fund/responsible-investment/exclusion-of-companies/ 46 For an example, see: Robeco Institutional Asset Management. 2019. Exclusion Policy Robeco. Available at: www.robeco.com/docm/docu-exclusion-policy-and-list.pdf 47 MSCI. 2020. The Global Industry Classification Standard (GICS). Available at: www.msci.com/gics 477 478 Chapter 8 © CFA Institute. For candidate use only. Not for distribution. Integrated Portfolio Construction and Management Another challenge is the treatment of asset classes and securities that fall outside of the traditional spectrum of responsible investment, which has generally been focused on: ► listed equities; ► listed corporate debt; and ► real assets. Indeed, the PRI itself acknowledges this limitation in the language of its signatory commitment, which recognizes that ESG may impact the performance of portfolios to “varying degrees across companies, sectors, regions, asset classes and through time.”48 As discussed earlier, ESG integration has a natural bias towards company-related assets, manifested in capital markets through equities and fixed income. With oversight of these assets, management teams and boards of directors drive decision making and long-term corporate strategy with feedback loops to shareholders and other stakeholders. However, other assets classes that lack the directed actions of a management team or board of directors prove more problematic. For instance, synthetic assets (currencies, interest rate derivatives, broad-based equity indexes, and commodity futures) are not single-operated assets and fall outside the conventional framework of ESG analysis. For some security types, it is possible to draw tenuous linkages between, say, currency forward contracts and the ESG profile of the underlying sovereign issuer, but other instruments are more difficult. For example, an interest rate swap represents a derivative contract that exchanges the floating interest rate payment of, say, a sovereign bond or loan for a fixed interest rate. Investors should certainly be aware of the underlying risks to that sovereign payment, but simply netting out the ESG risk profile of the same sovereign on both sides of the contract effectively creates a wash or cancellation. In addition, investment strategies, particularly at the multi-asset level, commonly invest in indexes for various reasons, including for cash management to cover potential redemptions by investors. Within this context, it is complicated and often can become expensive to frequently break down indexes from a screening perspective. Widely traded, liquid indexes are generally easier and less costly to decompose into their constituent or member weights, while the opposite is true for less popular, thinly-traded indexes. Hence, while an investor may maintain a formal exclusion list, they may also include a specific policy in their exclusion policy that omits indexes in the interest of efficient portfolio management. 8 ESG SCREENING WITHIN PORTFOLIOS AND ACROSS ASSET CLASSES: FIXED INCOME, CORPORATE DEBT, AND ESG BONDS 8.1.6 apply ESG screens to the main asset classes and their sub-sectors: fixed income; equities; and alternative investments 48 PRI. 2020. Signatories’ Commitment. Available at: https://www.unpri.org/pri/what-are-the-principles -for-responsible-investment Fixed income Equities Equities, fixed income JP Morgan ESG EMD MSCI ESG S&P (DJSI) ESG Real assets – infrastructure and real estate Global Real Estate Standards Board (GRESB) ESG Benchmark X X X X X X X X ESG X X X X X X X E X X X X X X X S X X X X X X G X X X X X X X ESG X X X X X X E X X X X X X S Ratings X X X X X X G GRESB ESG benchmark leverages GRESB's position as the leading investor initiative focused on real assets and infrastructure with a focus on commercial and residential real estate. ICE manages roughly 40 ESG-related indexes. Driven on MSCI ESG data, ICE indexes – covering equities, fixed income, and real estate – include: thematic (environmental, water, energy); ESG best practices; and factors (such as diversity and inclusion). Supports partner index and passive strategies (such as STOXX, SGX, S&P, iShares, and Nifty) that employ different approaches (including negative screening, ESG ratings, low carbon and gender diversity). Best-in-class indexes based on an ESG assessment of 4,500 corporates. Rules-based selection of top 10% to 30% (global or regional) of sustainable market cap based on ESG score. DJSI also offers indices with exclusions screens (weapons, alcohol, tobacco, gambling and pornography). Offers more than 1,000 ESG indexes. Methodology is based on ESG ratings with screening criteria available (tobacco, weapons, coal, fossil fuel, Catholic, and Islamic values). Governance factor measures UN Global Compact compliance only. Designed for both corporate and sovereign emerging market debt. Combines exclusionary screening against worst offenders alongside ESG ratings integration. Adjusts constituent weights based on composite ESG score for each issuer which overweights green bonds, and companies with better scoring ESG profiles. Applies FTSE Russell ESG ratings data to select companies with at least a 3.1 (developed) and 2.5 (emerging) rating out of 5. Companies exposed to "significant controversies" and certain business activities (tobacco, weapons and coal) are also excluded. Rates above 4,000 securities in developed and emerging countries on 300 ESG indicators. Measures companies' revenue exposure and management to green and brown (fossil fuel) exposure. Description Source: Adapted from the Journal of Environmental Investing. Douglas, E., T. Van Holt, and T. Whelan. 2017. “Responsible Investing: Guide to ESG Data Providers and Relevant Trends.” Journal of Environmental Investing 9 (1): 92–114. Available at: www.thejei.com/wp-content/uploads/2017/11/Journal-of-Environmental-Investing-8-No.-1.rev_-1.pdf Equities, fixed income Intercontinental exchange (ICE) ESG Equities Equities FTSE4Good Sustainalytics Equities Asset class FTSE Russell ESG Indexes Indexes Exhibit 15: Examples of ESG Indexes, Benchmarks, and Their Methodologies (January 2021) © CFA Institute. For candidate use only. Not for distribution. ESG Screening within Portfolios and across Asset Classes: Fixed Income, Corporate Debt, and ESG Bonds 479 Fixed Income (Government, Sovereign, Corporate, and Other) Generally speaking, ESG integration in fixed income has experienced a good deal of catch up relative to listed equities. However, there is still significant differentiation across the sub-asset classes. In Exhibit 16, Mercer’s ratings for ESG integration within credit subclasses reveal a greater number of higher ratings — ESG1 and ESG2 — in investment-grade credit, emerging markets debt, and buy-and-maintain strategies, while government debt and high-yield credit experience lower degrees of integration. As we will discuss, lower levels of ESG integration in areas like sovereign debt and high-yield credit often reflect a scarcity in ESG ratings and datasets and ratings, particularly in the unlisted credit markets. Exhibit 16: ESG Ratings across Fixed-Income Sub-Asset Classes 100% 90% 80% ESG4 ESG3 ESG2 Buy and maintain 0% Investment grade 10% Multi-asset credit 20% Unconstrained 30% High yield 40% Aggregate 50% Emerging markets debt 70% 60% Absolute return Chapter 8 Government 480 © CFA Institute. For candidate use only. Not for distribution. Integrated Portfolio Construction and Management ESG1 Source: MercerInsight (2020).49 Corporate Debt Corporate debt is now enjoying greater levels of ESG integration. In some regards, this should not be surprising. Issuers of equity also tend to issue debt. Indeed, there is growing evidence of ESG-incorporated methodologies yielding meaningful performance differentials. First, it is worth briefly highlighting why debt is distinct from equities. The debt issued by a single corporate — or sovereign, for that matter — often represents multiple credit risk profiles across bond issuances. These bond issuances represent different maturities, which refer to the payment date of a loan. In contrast, companies issuing equity generally issue one common share class.50 The temporal dimension across multiple debt maturities and credit risk profiles arguably lends itself to a more granular comprehension of ESG issues and their materiality. 49 MercerInsight. 2020. Responsible Investment in Fixed Income. Information on the aggregation methodology can be found in Appendix 2 of the report. All data as of 1 December 2019. Available at: www.mercer.com/our-thinking/wealth/responsible-investment-in-fixed-income.html 50 While most corporations maintain one common share class, there are companies — notably, Alphabet and Facebook — that operate multiple share classes. Different share classes may contain different shareholder rights, such as voting rights, dividend payouts, and rights to capital and special rights. MSCI ESG Research, Bloomberg Barclays Indexes, Barclays Research. Sustainalytics corporate ESG data are based on ESG Rating methodology, which has now been replaced with the ESG Risk Rating Methodology. Sustainalytics ESG Research, Bloomberg Barclays Indexes, Barclays Research. Sustainalytics corporate ESG data are based on ESG Rating methodology, which has now been replaced with the ESG Risk Rating Methodology. © CFA Institute. For candidate use only. Not for distribution. ESG Screening within Portfolios and across Asset Classes: Fixed Income, Corporate Debt, and ESG Bonds For example, 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. Exhibit 17 illustrates examples of two investment-grade bond portfolios with an ESG tilt applied. Although the short times (August 2009 to April 2016) limit the ability to make a strong performance claim across multiple economic cycles, both bond portfolios suggest that high ESG portfolios outperform low ESG portfolios despite being driven by different ESG methodologies. However, it is important to bear in mind that after the global financial crisis of 2008-09, ‘quality’ as a factor outperformed while ‘value’ largely underperformed. Given the strong correlation between high ESG and ‘quality’ among ESG vendors, it is important to note that the ESG-driven performance returns are not necessarily causal. Exhibit 17: Investment-Grade Bond Portfolio Performance (High ESG over Low ESG) Cumulate performance % of a high-ESG portfolio over a low-ESG portfolio using MSCI ESG data33 5.5 US Investment Grade Europe Investment Grade 4.5 4.0 US Investment Grade 3.5 Europe Investment Grade 3.0 2.5 3.5 2.0 2.5 1.5 1.0 1.5 0.5 0.5 –0.5 Cumulate performance % of a high-ESG portfolio over a low-ESG portfolio using Sustainalytics ESG data 34 0.0 -09 an-10 an-11 an-12 an-13 an-14 an-15 an-16 an-17 J J J J J J J J Jan –0.5 -09 an-10 an-11 an-12 an-13 an-14 an-15 an-16 an-17 J J J J J J J J Jan Source: Barclays.51 Exhibit 18 illustrates an ESG evaluation framework developed by BlueBay Asset Management, a fixed-income specialist asset manager. Based on an ESG integration approach, the framework leverages third-party ESG data to produce proprietary issuer ESG metrics: ► The Fundamental ESG Risk Metric examines fundamental ESG risk at the issuer level. 51 Barclays. 2018. The Case for Sustainable Bond Investing Strengthens. Sustainalytics data based on the firm’s legacy ESG ratings. Available at: www.investmentbank.barclays.com/content/dam/ barclaysmicrosites/ibpublic/documents/our-insights/ESG2/BarclaysIB-ImpactSeries4-ESG-in-credit -5MB.pdf 481 482 © CFA Institute. For candidate use only. Not for distribution. Integrated Portfolio Construction and Management Chapter 8 ► The Investment ESG Score operates at the bond security level. The ESG score takes into account varying credit risk sensitivities, which result from the exposure to ESG risk factors. These ESG risk factors are inherently present as a function of the bond’s features (or characteristics). The ESG Score is unique in that it examines ESG both as risk and as opportunity within the overall score. While useful at the issuer level, its value and differentiation for both its internal investment teams and investors lies in elevating the picture of ESG risk from the individual bond to the single issuer level — and ultimately understanding ESG risk within a given credit portfolio. Exhibit 18: Credit Investment-Grade Corporates Portfolio — Issuer ESG Metrics Summary Very Low ESG Risks Low ESG Risks Medium ESG Risks High ESG Risks Very High ESG Risks +2 +1 0 -1 -2 Long 0.009 0.135 0.509 0.182 0.019 0.013 0.078 0.347 0.333 0.083 Short 0 -0.0013 -0.0016 -0.0005 0 0 -0.001 -0.0007 -0.0017 0 Note: The Fundamental ESG (Risk) Rating, assigned at the issuer level, relates to how well the borrower is managing the material ESG risks it faces, capturing current performance as well as trajectory of travel. The Investment ESG Score, assigned at the security level, relates to the extent to which the ESG risks are considered investment relevant and material, and if so, the direction and extent of that potential credit risk. Source: BlueBay Asset Management (2020) ESG Bond Types New forms of credit issuance have emerged, designed to raise funding to deliver social and environmental objectives alongside a financial return. With the World Bank often playing a leading role in developing these markets and advising bond issuers, ESG-oriented bonds are typically organized around a few s

CFA Institute Chapter 8: Integrated Portfolio Construction and Management PDF

Document Details

Tags

Related

Summary

Full Transcript

Upgrade to continue