Complying with sustainability criteria is one of the conditions investors can stipulate for their portfolios. In most cases they have other criteria in mind as well.
Examples include the portfolio’s composition in terms of asset classes, the risks taken, sectors to be excluded, regions on which to focus, or other criteria. A strategy whose starting point is a balanced approach across various dimensions seems ideally suited to taking ESG criteria into account, either as a core focus or an added extra.
When choosing their core portfolio, many investors opt for a balanced investment strategy that also takes their personal preferences into account. Balanced profiles like this are therefore offered in various formats. Firstly, they vary in terms of their risk profile and – a closely related aspect – their investment horizon. Secondly, investors need to decide if, for example, alternative investments or exposure to emerging markets should be permitted, or whether there should be a pronounced domestic market bias. These criteria ultimately boil down to restrictions for the relevant portfolio managers. But we should not forget that there are now more and more products on offer that meet sustainability criteria.
Sustainability as an investment restriction
At first glance, ESG – environmental, social, and governance – criteria add an extra limitation. Inevitably, the investment universe shrinks if certain corporations and securities that do not meet the defined ESG criteria are automatically excluded from the portfolio. A reduced universe is not detrimental to performance if the eliminated segments have increased downside risk, such as the coal industry.
Many investors see adherence to ESG criteria as a positive in itself. This can be due to intrinsic motivation of the individual investor, akin to paying a different price for organic produce at the supermarket. In addition, many institutional investors are subject to restrictions in relation to responsible investment based on articles of association or their stakeholders’ requirements. But it goes without saying that all these investors also have an interest in these preferences being implemented as efficiently as possible by keeping any losses to a minimum.
A professionally managed, diversified portfolio has a clear structure and a systematic investment process. The first priority involves determining and annually reviewing the long-term strategic asset allocation as per the desired risk/return profile. Portfolio managers have to check whether the asset classes in the target universe can be replicated using sustainable instruments. To take one example, the offering in the alternative investments space is frequently insufficient.
Tactical allocation based on short-term market expectations is intended to exploit opportunities in asset classes, regions, or currencies. The actual sustainability criteria will be taken into account as part of the stock picking process.
Elements/components of a holistic approach to ESG
A holistic approach involves more than just the widespread exclusion criteria. It is important that positive selection criteria are also incorporated into the investment process. Exercising voting rights as part of active ownership and dedicated ESG reporting are other key elements of a holistic approach.
The benefits of ESG-focused investments
A meticulous and systematic approach entailing a broadly diversified, balanced investment solution can largely offset any losses caused by narrowing the investment universe due to ESG criteria. Corporations lacking awareness of environmental, social, or governance issues that could result in incidents harmful to their business will be identified and excluded during the sustainability analysis process.
It is now becoming more and more apparent that firms which meet ESG criteria frequently perform better than the broader market. A long-term approach, prudent management, and a focus on the needs of clients who are increasingly prioritizing sustainability – also as part of their consumer behavior – is proving to be beneficial across sectors and regions. Investors can benefit from a professionally managed and balanced strategy without running the risk of suddenly having either too much or too little exposure to certain regions, sectors, or asset classes. In addition, this type of solution is able to apply sustainability criteria systematically and consistently. This is no easy matter when it comes to multi-asset class portfolios.
A balanced approach to ESG – a compelling combination
The aim is to achieve a balanced solution that takes account of investors’ preferences, the targeted risk/return profile, and the current market situation in constructing and continuously adjusting a broadly diversified portfolio. This offers a framework ideally suited to implementing an ESG-focused approach that deviates only marginally from the tried-and-tested investment process. It provides investors with a sustainable portfolio without significant shortfalls in returns – and with even the potential for excess returns – versus a conventionally managed portfolio.