Ch 8 ESG Integrated Port Constr & Mgmt

Question 1

What should an ESG policy formally outline?

Answer 1

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
1. the investment approach and
2. degree of ESG integration within a firm.
Particularly, asset managers should have
3. ESG policies for asset classes and
4. 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.
It is worth noting that investor organizations are now addressing policy development in alternative investment areas, including hedge funds.

Question 2

What is Factor risk allocation?

Answer 2

Factor risk allocation focuses on creating a diversified portfolio based on sources of risk. ESG issues can lead to changes in baseline risk assumptions and building in new ESG-related risk factors.

Dynamic asset allocation adjusts portfolio allocations as risk tolerances change. ESG issues can change baseline assumptions over different time horizons.

Mean-variance optimization uses to efficient frontier and is highly sensitive to baseline assumptions. ESG issues could impact assumptions related to risk, return, and correlations among asset classes.

Total portfolio analysis focuses on risk budgeting, providing both top-down and bottoms-up analysis. This allows more flexibility in incorporating ESG issues.

Question 3

Passive indices are least likely to

Passive indices are most likely to

Answer 3

Passive indices are least likely to use engagement to change industries.

Passive indices are likely to
exclude some problematic industries.
include high ESGs scores in each industry.
limit exposure to certain industries.

Explanation

Active managers may use an engagement strategy to help drive change.
Passive indices use different methodologies including
full exclusion,
limiting exposure to certain industries, and
including the highest scoring companies in each industry and weighting the industries.

Question 4

Reasons for Again ESG rating coverage gap may be due to

Answer 4

the ESG ratings coverage gap of a high-yield credit portfolio where roughly 25% of the
strategy’s positions are unrated.
Again, this coverage gap may be due to a number of reasons:
▶ the corporate bond issuer may be too small for ESG ratings providers to score;
▶ the bond may be a new issuer that has not yet been scored; or
▶ it may be unlisted debt.

Regardless of the reason, it is an important example for why and how multiple ESG data sources should be considered when assessing the ESG exposure profile of a portfolio. Noting coverage gaps when reporting to the investors of a portfolio is not only informationally helpful, but it preserves the integrity of the ESG screening process. That said, no best practice currently exists in terms of how to treat ESG coverage gaps within a portfolio.

However, there are two potential approaches to address this issue:
1. The simplest approach is to simply rescale the scoreable portion of the portfolio to 100% by proportionally resizing each scoreable position.
2. The second approach is to apply Bayesian inference to the coverage ratio, effectively grossing it up to 100% by probabilistic inference. Note that both approaches are reasonable with coverage gaps of up to 25%.

Although no hard rule or best practice exists, normalising for a gap in excess of 25% should be reviewed for whether it over- or underrepresents a portfolio’s true ESG exposure. This potentially undermines the integrity of ESG analysis at the portfolio level for the manager and may misrepresent the ESG exposure of the portfolio to the fund’s investors.

Question 5

What are the goals for active ownership?

Answer 5

Active ownership “is the use of the rights and position of ownership to influence the activities or behaviour of investee companies.” Its investment approaches employ a number of different shareholder strategies aimed at driving positive change in the way a company is governed and managed. In effect, it takes the opposite approach of negative screening, as it views the act of divestment alone as incapable of collectivising and directing investor preferences towards change.

Active ownership may leverage direct engagement between investor and company management, collaborative engagement where investors collectively drive for change, filing shareholder proposals and resolutions as well as a proxy voting strategy that is driven by a clear agenda to: (the goals for active ownership)
▶ encourage greater disclosure;
▶ improve transparency; and
▶ increase stronger awareness around ESG issues.

Companies that trade at meaningful discounts to their peer group or whose debt is distressed often have poor ESG metrics. Through influencing companies’ behaviour, the strategy is based on the theory that a linkage exists between improvements in corporate ESG metrics and the re-rating in equity value or credit through tighter spreads.
Academic support for the efficacy of active ownership is relatively sparse. While there are numerous case studies around company-specific engagements, there is more limited data measuring prolonged engagements and outcomes on their effects across dedicated active ownership strategies.

Question 6

Which type of investment appears to have the most robust analysis around do no significant harm (DNSH), which is used in exclusionary screening?

Answer 6

It is worth noting that recently introduced EU regulation – specifically, the EU Sustainable Finance Taxonomy, which subsequently feeds into the SFDR – introduces the principle of DNSH. Investment funds characterised as Article 9 under the SFDR must abide by the DNSH principle which will act in effect as a negative screening tool. Starting with the introduction of SFDR on 10 March 2021, investors that market investment strategies into the EU that are characterised as ‘environmentally sustainable’ will need to disclose how they have used the EU Taxonomy to assess the sustainability of the portfolio’s underlying investments.
Under the DNSH principle in the Technical Expert Group Final Report on the EU Taxonomy, economic activities that make a substantial environmental contribution to the climate change mitigation or adaptation must not cause significant harm to the other designated environmental objectives. These include:
▶ sustainable use and protection of water and marine resources;
▶ transition to a circular economy, waste prevention and recycling;
▶ pollution prevention and control; and
▶ protection of healthy ecosystems.98
The PRI has produced a number of case studies applying the DNSH principles and examining its implications.

Private equity and real estate investors appear to have constructed the most robust DNSH analysis, given their oversight on building-specific projects and construction. However, many of the case studies point to a number of challenges, from sourcing available, comparable data to identify and verify DNSH activities to isolating the specific share of revenue affected by a controversy.

Question 7

Which type of investment appears to have the most robust analysis around do no significant harm (DNSH), which is used in exclusionary screening?

Answer 7

It is worth noting that recently introduced EU regulation – specifically, the EU Sustainable Finance Taxonomy, which subsequently feeds into the SFDR – introduces the principle of DNSH. Investment funds characterised as Article 9 under the SFDR must abide by the DNSH principle which will act in effect as a negative screening tool. Starting with the introduction of SFDR on 10 March 2021, investors that market investment strategies into the EU that are characterised as ‘environmentally sustainable’ will need to disclose how they have used the EU Taxonomy to assess the sustainability of the portfolio’s underlying investments.
Under the DNSH principle in the Technical Expert Group Final Report on the EU Taxonomy, economic activities that make a substantial environmental contribution to the climate change mitigation or adaptation must not cause significant harm to the other designated environmental objectives. These include:
▶ sustainable use and protection of water and marine resources;
▶ transition to a circular economy, waste prevention and recycling;
▶ pollution prevention and control; and
▶ protection of healthy ecosystems.98
The PRI has produced a number of case studies applying the DNSH principles and examining its implications.

Private equity and real estate investors appear to have constructed the most robust DNSH analysis, given their oversight on building-specific projects and construction. However, many of the case studies point to a number of challenges, from sourcing available, comparable data to identify and verify DNSH activities to isolating the specific share of revenue affected by a controversy.

Question 8

What is Positive alignment or best-in-class?

What are the key challenge these strategies faced?

Answer 8

Positive alignment or best-in-class represents, to some degree, the inverse of exclusionary screening. It
employs a given ESG rating methodology to identify companies with better ESG performance relative to its industry peers. This approach is typically expressed by investing in the top decile, quintile or quartile, based on prescribed ESG criteria. The consistency of the ranking methodology and the portfolio’s position-weighted exposure to higher-ranked companies are vital for this class of ESG strategies.

The diversity of ESG ratings methodologies and lack of ratings convergence are a key challenge these strategies face.

They may score highly based on the portfolio manager’s methodology but score more poorly on another set of ESG metrics used by the fund’s investor or, for instance, a fund distribution platform like Morningstar.
Hence, best-in-class portfolios will be tested on transparency as well as consistency. Because of this rating or score-imposed constraint, best-in-class strategies will generally have much less latitude to perform and apply proprietary research on lower-scoring companies that happen to exhibit positive
momentum or improvement in their ESG metrics. For example, recent research has begun to demonstrate a correlation between positive momentum in ESG scores and financial returns.101
Finally, a common criticism for best-in-class ESG strategies is that their focus yields diminishing ESG returns with little opportunity to demonstrate incremental gains via active ownership efforts.

Question 9

What baseline metrics that due diligence focuses on establishing to evaluate and compare managers?

Answer 9

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 multimanager 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.

Question 10

the PRI recognises three main approaches to screening

Answer 10

Broadly speaking, the PRI recognises three main approaches to screening:

1. Negative screening represents the avoidance of the worst performers. Functionally speaking, an investor might apply screening towards:
   » sectors; » regions; » issuers; » business activities and practices; » product and services; and
   » even security types such as certain commodities.
2. Positive screening is investment into the best ESG performers relative to industry peers across, as in point 1, different criteria.
3. Norms-based screening applies existing normative frameworks in order to screen issuers against
   internationally-recognised minimum standards of business practice. Screening generally applies globallyrecognised frameworks like treaties, protocols, declarations and conventions including:
   » the UN Global Compact; » the UN Human Rights Declaration; » the ILO’s Declaration on Fundamental Principles and Rights at Work; » the Kyoto Protocol; and » the Organisation for Economic Co-operation and Development (OECD) Guidelines for Multinational Enterprises.

Question 11

A manager that wants to optimize a portfolio for multiple factors may want to

Answer 11

Portfolios that optimise for multiple factors – particularly a combination of absolute data and
subjective rankings – may have to accept higher active risk to achieve both targets. Under this simulation, a portfolio manager may choose to optimise the portfolio to achieve the highest MSCI ESG ratings while reducing carbon emissions (100 to 150 basis points (bps)) with an associated increase to tracking error of 220 to 300 bps.

A more conservative approach that seeks to minimise tracking error might instead target a tracking error of 150 to 200 bps, which achieves top ESG scores and a higher carbon emissions reduction.

A manager that wants to optimize a portfolio for multiple factors may want to target a lower tracking error.

Higher active risk may result from meeting all targets when optimizing a portfolio for multiple factors, which may use quantitative data and/or subjective screening. It may not be possible to limit it to quantitative data depending on the factors.
The manager should assess the tradeoffs to achieve an acceptable tracking error against its benchmark, especially if there are diminishing benefits as tracking error increases.

Question 12

A manager that wants to optimize a portfolio for multiple factors may want to

Answer 12

Portfolios that optimise for multiple factors – particularly a combination of absolute data and
subjective rankings – may have to accept higher active risk to achieve both targets. Under this simulation, a portfolio manager may choose to optimise the portfolio to achieve the highest MSCI ESG ratings while reducing carbon emissions (100 to 150 basis points (bps)) with an associated increase to tracking error of 220 to 300 bps.

A more conservative approach that seeks to minimise tracking error might instead target a tracking error of 150 to 200 bps, which achieves top ESG scores and a higher carbon emissions reduction.

A manager that wants to optimize a portfolio for multiple factors may want to target a lower tracking error.

Higher active risk may result from meeting all targets when optimizing a portfolio for multiple factors, which may use quantitative data and/or subjective screening. It may not be possible to limit it to quantitative data depending on the factors.
The manager should assess the tradeoffs to achieve an acceptable tracking error against its benchmark, especially if there are diminishing benefits as tracking error increases.

Question 13

ESG real estate benchmark

Answer 13

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.

Question 14

The biggest limitation of ESG indices is that some indices ???

Answer 14

The biggest limitation of ESG indices is that some indices: are thinly traded.
In addition, investment strategies, particularly at the multi-asset level, commonly invest in indices 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 indices from a screening perspective. Widely traded, liquid indices are generally easier and less costly to decompose into their constituent or member weights, while the opposite is true for less popular, thinly-traded indices. Hence, while an investor may maintain a formal exclusion list, they may also include a specific policy in their exclusion policy that omits indices in the interest of efficient portfolio management.

Question 15

it is possible to organize exclusions across four basic categories?

Answer 15

it is possible to organise exclusions across four basic categories:
1. universal;
2. conduct-related;
3. faith-based; and
4. idiosyncratic exclusions.

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.

Question 16

The process of portfolio
optimization requires defining an upper and lower bound for a given variable and then applying it on an
absolute or benchmark relative basis.

Answer 16

ESG integration should not be seen as detrimental to the risk–return dynamic of portfolio optimisation. Rather,
it should be understood as simply another factor that potentially may enhance the risk and return profile. Like
other ESG considerations, its construction and weighting in the context of the overall portfolio ultimately rests
on how high a priority the investor assigns it, relative to other factors. Because of this, portfolio optimisation is
an increasingly important means to apply ESG criteria. Nonetheless, investors must weigh the trade-offs when
quantitatively applying constraints to optimise for ESG outcomes within a portfolio. The process of portfolio
optimisation requires defining an upper and lower bound for a given variable and then applying it on an
absolute or benchmark relative basis.

Question 17

Negative screening

Many investors apply exclusions to restrict exposure to certain sectors or securities that conflict with their
worldview.

Answer 17

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, the first formal approach was aligned to religious values, beginning with the Methodists.
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.ii

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.

Question 18

The correlation among six third-party data providers

Answer 18

The correlation among six third-party data providers was 0.458 for the average ESG ratings. Correlations were lower for the different components with 0.429 for environmental, 0.321 for social, and 0.200 for governance.

Question 19

The reason for third-party and proprietary ESG data

Asset owners and managers increasingly recognise 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 to a single provider and creates greater context for discussion when reviewing the risk profile of a
portfolio.

Answer 19

Portfolio managers use both third-party and proprietary ESG data to reduce risk of overreliance on a single provider. Combining third-party and proprietary ESG data also helps the managers differentiate how the data understands portfolio risk and enhances the context when discussing and reporting on the portfolio’s risk. Managers may not want to automate ESG risk reporting because there is subjectivity in how different ESG factors as assessed, resulting in deviations in ESG ratings between providers.

Question 20

Which type of fixed-income sub-asset class is most likely to have a greater number of higher ESG ratings?

Answer 20

Investment grade debt is most likely to have a greater number of higher ESG ratings.

Companies that issue equity also tend to issue debt, and large companies tend to have resources to provide more ESG reporting.

Government debt has the lowest level of ESG integration within fixed income.

Question 21

Sustainability bonds

sustainability-linked bonds

Answer 21

Sustainability bonds allow issuers to offer more broadly defined bonds that still create a
positive social or environmental impact.

Not to be confused with sustainability bonds, sustainability-linked bonds (SLBs) provide
financing to issuers who commit to specific improvements in sustainability outcomes.
These outcomes may be defined as environmental, social and/or governance-related.

Question 22

What is an example of a discretionary strategy within ESG portfolio integration?

Answer 22

ESG can be integrated within discretionary and quantitative strategies. Discretionary focuses on depth of analysis, and quantitative focuses on rules to create breadth and reduce costs. Most ESG investment strategies use the fundamental portfolio approach, which is a discretionary strategy that uses bottom-up analysis and ESG factors to create an investment thesis, and then assesses risk and correlations at the portfolio level. There are also several quantitative strategies including beta-plus funds, single and multifactor ESG models, and a custom index with exclusion criteria.

Question 23

ESG integration should be considered in light of two different investment strategies:

Answer 23

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 minimise 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.

Question 24

▶ Physical risks. These represent the physical risks manifested by climate change that may impact businesses’
operations, strategy, infrastructure, workforce or markets; it may carry wider implications across the
investment value chain and to the financial system.
▶ 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.

Answer 24

There are two major types of climate-related risks: physical and transition. Hurricanes are an example of physical risks, which can impact the operations, strategy, infrastructure, and workforce of a business. Risks related to transitioning to a low-carbon economy deal are impacted by changes in legal, regulatory, policy, technology, and markets.

Question 25

What type of external research is a portfolio manager most likely to apply?

Answer 25

Practitioners have access to a wide range of resources such as 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, nongovernmental organizations research, governmental agencies and central banks, and multilateral institutions and agencies. While academic studies can link ESG and investment returns, they are not widely applicable in practice.

Question 26

The PRI outlined the following six-step process for implementing screening as an investment approach:

Answer 26

The PRI outlined the following six-step process for implementing screening as an investment approach:
1. identify client priorities;
2. publicize clear screening criteria;
3. introduce oversight;
4. adopt investment process;
5. review portfolio implications; and
6. implement monitoring, reporting, and audit.

Question 27

Managers with a multi-asset strategy may want to use highly liquid indices to do what?

Answer 27

Managers with a multi-asset strategy may want to use highly liquid indices to costs and for cash management for investors’ potential redemptions.

Many indices use negative screening based on certain criteria, but it would be rare to find investors with perfectly overlapping screening criteria based on their worldviews.

Question 28

ESG integration in direct real estate investments is likely to consider?

Answer 28

Real estate investments can integrate ESG by considering green building materials and design, social considerations such as building entry-level homes, and climate risk by assessing risks to natural hazards.

Related party transactions do not apply to a direct investment in real estate, although it could be relevant to an indirect investment in a real estate fund managed by a sponsor that offers multiple funds.

Question 29

CFA Institute’s ESG integration framework works its way out from the core in the order of the following levels?

Answer 29

CFA Institute’s ESG integration framework expands outwards, adding more robust layers of analysis across more dimensions. The framework works its way out from the core to
(1) the research level, then
(2) the security level including security valuations for equity and fixed income, and finally
(3) the portfolio level including asset allocation, portfolio construction, scenario analysis, and risk management.

Question 30

Which is most likely to result in higher deviations from an optimal portfolio?

Answer 30

Tighter constraints on targeted exposure can increase the likelihood of deviations from an optimal portfolio.

Managers can use skewness in a dataset to reach their targeted exposure by targeting either end. For example, they can invest in the top quartile or exclude the bottom quartile.