Step Two: Forecasting Expected Return Drivers
Once a portfolio team has identified appropriate return streams, it can isolate and forecast the drivers of expected returns, risks and correlations. In our view, employing a return-distribution approach makes the process more robust than point-return estimates.
Bear in mind that expected returns for ESG index components don’t have to be positive. If ESG hasn’t yet been fully priced into markets, and if flows continue to support a strategy, expected alpha could be positive. In contrast, an organization may wish to promote socially positive activities in segments where markets have already priced out alpha, so the risk/return trade-off from higher portfolio concentration in those segments could be negative.
Return forecasts must account for a lack of uniformity in ESG characteristics within sectors. Natural resources, for example, include both backward-looking fossil fuel strategies and forward-looking renewable strategies. Backward-looking strategies will likely rate lower on ESG but offer alpha potential from issuers who improve their ESG practices. They’re also more likely to have a value tilt, while forward-looking issuers tend to be more growth oriented.
Step Three: Constructing an ESG-Aligned Portfolio
Using inputs from the previous steps, portfolio construction seeks to design a portfolio that maximizes expected returns subject to stated objectives and constraints, including ESG guidance. The engine for portfolio construction varies: mean-variance optimization, risk budgeting, simulation and fundamental judgment are among the choices.
ESG can be incorporated at this step as an explicit objective — perhaps maximizing a portfolio’s score or minimizing carbon emissions — alongside maximizing risk-adjusted returns. ESG-related constraints can also be plugged in to guide the outcome. For example, minimum ESG scores might be specified for the overall portfolio, asset classes or even individual strategies.
Allocation ranges can be specified for ESG-integrated strategies, levels of ESG scores or carbon emissions. In each case, specific objectives or constraints can be configured to align a portfolio with transnational arrangements, such as the EUSFDR Article 9 or the Paris Agreement.
Step Four: Evaluating Underlying Investment Managers
Once the portfolio blueprint is finalized with generic investment strategies, the portfolio team begins selecting the specific investment managers best equipped to deliver what’s needed from each building block. Individual managers’ risk/return exposures must be assessed individually versus their benchmarks and collectively to form a coherent portfolio.
For instance, an allocation might call for a low-carbon indexed strategy — fillable by a passive exchange-traded fund or active manager. Underlying risk exposures (such as value or growth) may differ from the index. Security-selection alpha might also be embedded, from high-conviction fundamental or systematic quantitative managers. Multi-asset portfolio teams must measure exposures, accepting or offsetting unintended ones with a complementary manager or overlay.
To ensure alignment with the IPS, portfolio teams must thoroughly vet managers’ ESG practices. If the IPS formally outlines manager expectations, it can serve as the ultimate basis for monitoring and measuring ESG results. Common metrics used include proprietary or third-party ESG scores, quantity and quality of issuer engagements, and expected improvement in ESG scores of managers’ holdings.
In terms of ESG-integration quality, the depth of integration an organization expects or accepts from managers is an important bar. Passive strategies may be cost efficient but also rudimentary in ESG integration. Active quantitative strategies can offer solutions for a wide range of ESG objectives and constraints. Fundamental managers frequently bolster engagement efforts as a way to drive better alpha and ESG outcomes.
Finally, investors should look at not only where managers are today but where they’re headed, because responsible investing continues to evolve rapidly. Climate change-scenario analysis, for instance, is rapidly becoming a priority, and we think this capability should be squarely in managers’ sights, despite the resources required and the still-developing nature of the technology and tools.
The Big Picture: Alignment Matters
For multi-asset investors, achieving targeted portfolio outcomes requires strong planning and effective implementation. These processes may be well understood for traditional risk and return considerations but may be less ingrained for the ESG dimension of asset allocation.
It’s not a simple task to secure end-to-end organizational ESG alignment, especially given the multitude of approaches, but the complexity of the task is exactly what makes alignment so valuable: upstream clarity limits downstream confusion. Even the best intentions can fall short without clear expectations and tangible metrics.
With a clear mandate and comprehensive approach, strategic asset allocation can improve the odds of achieving organizational ESG objectives. In our view, an organization’s IPS is the best place to hardcode ESG expectations.