Integrating ESG into a portfolio. Tips for external asset managers.
Many external asset managers (EAMs) are now integrating ESG approaches (Environmental, Social and Governance) into their own advisory and investment process. But what has to be considered in this context? The following article summarizes the most frequently asked questions that have been asked in various discussions with external asset managers.
How should client preferences be identified and recorded?
In order to avoid erroneous decisions or disappointments, specific client references should be identified, saved in (client) profiles, and regularly updated. In addition, detailed questionnaires – e.g. that contain criteria for the exclusion of specific business practices or define minimum standards for the companies to be included – can prove particularly helpful when determining threshold levels and specific client requirements.
How can ESG data be integrated into an advisory process?
There are a large number of ESG data providers that highlight the various sub-categories of a sustainability evaluation. These ensure that client portfolios are in harmony with the relevant understanding of ESG investments and the client's preferences. Furthermore, they facilitate a structured discussion of ESG-related risks and the compilation of further information on specific sub-segments of the portfolio, such as its CO2 profile, for example.
Depending on the type of data, there are various ways in which ESG can be integrated into the advisory process.
- Ratings for individual securities:
This approach is a good starting point for discussing an existing portfolio. The advantage is that it allows for ratings to be amalgamated at portfolio level, which then provides an overall portfolio ESG rating. This in turn allows for a comparison with the wider market or with alternative portfolios.
- Keeping abreast of reported controversial company activities:
With this approach, the focus is on potential dangers in existing portfolios. Reports on controversial activity can be seen as "red flags" for companies that have become embroiled in specific situations (e.g. major oil catastrophes, court proceedings, etc.). Screening the portfolio to identify companies involved in serious controversies can help to uncover risks or problems that a client does not want to be connected to.
- Measuring the involvement of companies:
Another approach is to identify a company's involvement in certain practices (e.g. munitions production or animal experiments) and then exclude those companies whose activity exceeds a specific threshold level.
As this approach has the effect of restricting the universe of companies in which investments may be made, it should be applied at the initial phase of portfolio construction.
- Measuring sustainable impact:
ESG data can also be implemented into the advisory process by measuring the impact that a portfolio has. This impact is defined by measuring the alignment of portfolio investments with the 17 United Nations Sustainable Development Goals (SDGs). However, this impact is typically not a financial metric, and is therefore difficult to measure.
All approaches are based on detailed, high-quality data sets. A number of high-level rating data sets are provided free of charge by certain providers. These high-level data elements often do not provide the necessary transparency for a specific ESG-related investment decision, however, which means additional licenses or services will be required.
How can funds be evaluated in a portfolio?
If pooled investment products such as investment funds form part of a client portfolio, it is important to consider what level of transparency can be obtained. One approach is to rely on the combined portfolio data of the fund on a "look-through" basis. In order for an evaluation to be carried out, the fund provider must grant access to the latest portfolio data. However, this approach on its own will not ensure that the proposed fund is always aligned with the client's ESG requirements, as the fund manager may switch investments, for example. A clear commitment on the part of the fund manager will therefore be required.
A second approach involves not considering the individual holdings of a fund, but looking at its overall ESG label or the fund manager's declaration. While this approach facilitates an ESG evaluation without undertaking a large amount of work, specific ESG preferences of the client may be overlooked. This makes complete portfolio analysis difficult.
What do I need to assess my own portfolio?
First of all, investors must be clear what they mean by "sustainable investing," and how they want to incorporate this aspect into the investment process. Once the investor has decided on a particular approach, there will be a number of providers of ESG ratings to choose from. Ratings are given for individual holdings and aggregated at portfolio level. The same applies to funds. Here ratings are assigned to the underlying holdings aggregated at fund level. This presupposes that transparency exists in respect of the fund holdings.
What is important when evaluating EM assets in the ESG context?
As the general rule of thumb, companies in emerging markets are less likely to report on their progress in the area of ESG. Accordingly, data quality can be a problem in certain markets. On the other hand, studies have shown that the application of ESG indicators when selecting emerging market investments can create added value, as this has the effect of reducing portfolio risk – particularly by ensuring improved governance standards.
How is CO2 output measured?
The most commonly used metric to identify the CO2 emissions of a company is CO2 intensity. CO2 intensity measures the level of a company's CO2 emissions per dollar of revenue. However, CO2 intensity is by definition a retrospective measurement, as it only takes into account previous emissions. For that reason, a number of providers have also developed assessment methods that give an idea of how well a company is prepared for a low-CO2 world.
What are SDGs and how they measured?
The 17 UN Sustainable Development Goals (SDGs) were agreed by 193 countries in 2015, to be implemented by 2030. The SDGs aim to promote cooperation between international private and public organizations in order to tackle global changes such as poverty, inequality, climate change, environmental destruction, peace, and justice. A number of ESG data providers highlight whether a particular company is in harmony with certain SDGs or not.
What about sectors with inherent exposure to environmentally damaging industries?
Companies active in sectors with inherent exposure to environmentally damaging industries typically have a lower overall ESG rating. However, rating providers generally arrive at their assessments by comparing a company's ESG measures with those of its competitors. This makes it possible to select the ESG leader within a sector that is best equipped to handle ongoing changes in the commercial and regulatory environment.
What approach should be taken with companies that are involved in controversial situations?
Controversies often mean that governance practices at the company in question have not been appropriately implemented. It is therefore important to scrutinize a company before deciding whether an investment is justifiable. Rating providers incorporate controversial situations into their evaluations, and regularly review whether there are updates on ongoing controversies.