Embedding ESG in your investment portfolio

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Embedding ESG in your investment portfolio

Earlier this year, Mark Carney, the Governor of the Bank of England, and François Villeroy de Galhau, the Governor of the Banque de France, warned that the global financial system faces an existential threat from climate change and must take urgent steps to reform.

In an article published in the Guardian, they said: "As financial policymakers and prudential supervisors we cannot ignore the obvious physical risks before our eyes. Climate change is a global problem, which requires global solutions, in which the whole financial sector has a central role to play."

Pension schemes and asset managers should take note as factors such as climate change can have long-term negative impact on a stock's fortunes. If a company engages in activities such as cultivating stranded carbon assets, its business strategy must surely not be sustainable.

Assessing ESG factors
The direction of travel is clear: the focus on responsible investing is making it increasingly important for pension schemes - and their managers - to include a consideration of environmental, social and governance factors in their investment strategies.

By paying attention to these characteristics, a scheme favours those companies which will tackle climate change, enforce good labour practices and have a well-governed and diverse board.

If a scheme uses an active manager then they can select one which selects stocks based on high ESG scores. It's likely an active manager would have their own methodology to assess these characteristics.

Portfolio tilts
But it is also possible for a scheme to favour those companies with a high ESG score in their passive portfolio. If an index provider does not have its own in-house model, it can instead use data from companies such as MSCI or Sustainalytics to rank the ESG scores of the companies.

The portfolio could then be tilted towards ESG factors by excluding those stocks with the lowest score. To maintain overall index sector/industry neutrality it's best, generally, to assess the companies within each sector/industry and then discard those companies with the lowest score.

If the index provider does not match the index sector weightings, there is a danger individual industries could be under- or over-weighted relative to the benchmark. This could introduce significant tracking error.

This ‘negative screening' has typically been the most common methodology for building indices with an ESG tilt. But a different approach is now emerging from investors who see a strong role for active engagement.

Consider a more positive approach
Rather than not investing in those companies with low ESG scores, some investors want to instead engage with those stocks with low scores to bring about real change in corporate behaviour.

Both of these approaches described above can be combined by, for example, only excluding the bottom 5% of companies rather than the bottom 10%. For those companies which remain in the portfolio with a poor ESG score, the investor can engage with management to get them to change their corporate behaviour.

For some investors, however, the decision to exclude will be based on ethical considerations rather than an assessment of an ESG score. For example, Dutch pension schemes will not invest in the manufacturers of cluster bombs.

There is another benefit to taking a more positive approach than simply tilting a passive portfolio towards those companies with a high ESG score: it should minimise the impact of tracking error.

The higher the number of exclusions - whether they are due to ethical considerations or because of a low ESG score - the more likely the performance of the tilted fund will deviate from its benchmark.

For most schemes, however, tracking error considerations should be less of a concern than ensuring the equity allocation will help them to achieve their overall investment goals while conforming to their responsible investment beliefs.

Match products to institutional appetites
With many large institutional investors now insistent that fund managers take consideration of ESG factors into account in their investment process, fund managers have little option but to comply. It is increasingly vital to have these products to be able to attract large institutional clients.

In our view, it will not be enough, however, for managers to apply their well-known negative screening processes - they should recognise the shift to much more active engagement to change corporate behaviour. They will need to match these changes in appetite with appropriate product.

Chris Head, head of Business Development, AMX