Chapter 8: Integrated Portfolio Construction Flashcards
What defines exclusion based investment?
Negative screening, prioritizes norms, non-engagement,
What defines ESG investing?
Positive screening, prioritizes measurability, reinforce engagement, reporting
What defines Impact investing?
Prioritizes intentionality and additionality, framework-orientated, impact-focused, measurable outcomes
In what areas should ESG integration at the porfolio level be active?
○ Portfolio exposure
○ Risk management
○ Performance and attribution
○ Asset allocation decisions
What should be included in the investment thesis that an security analyst develops?
○ Intrinsic value of a security
○ Credit analysis
○ Potential or rerating or derating in valuation
○ Potential risks
○ Short- and long-term catalysts, and
- Expected security earnings growth and cash flow profile
What is the task of a portfolio analysis and what are key challenges?
- Much broader scope than security analyst
- Aggregation of all underlying individual risks
- Challenge that ESG data and services are tailored to security-level analysis
- Particularly hard to assess risk-adjusted returns
- Primary role is to weigh security specific convictions against
○ Macro and microeconomic data
○ Portfolio exposure
- Sensitivities against potential shocks
What are parts of a ESG integration framework for portfolios?
○ Organizing principles and methodologies for ESG analysis
○ Identification and analysis of financial and ESG materiality at the individual security level
○ Approaches to build a composite picture of risk and exposure at a single portfolio level
○ Representation of ESG risks and exposure that informs a mixed asset strategy which may include many methodologies
- Also need to consider discretionary and quantitative strategies
What characterizes a discretionary portfolio investment?
○ Fundamental portfolio approach
○ It is process-orientated
○ Complement bottom-up financial analysis alongside ESG consideration to reinforce investment thesis of a particular holding
- Portfolio manager would then understand aggregated risks at the portfolio level across all factors to understand correlation and event risks, and potential shocks to a portfolio
What characterizes a quantitative portfolio investment strategy?
○ Traditionally, passive or index-based strategy, that impose a custom index typically with exclusion criteria
○ But can be qualitative, too
○ Rules-based and factor-orientated
. Getting more sophisticated, multi-factor ESG models
What the TCFD recommendations for integrated portfolio management ?
- Elevating Risk exposure metrics from the underlying asset level to the portfolio level
- E.g. company carbon footprint - portfolio managers now treat carbon exposure on a portfolio-weighted basis
What is the carbon-weighted portfolio exposure calculated?
- portfolio managers now treat carbon exposure on a portfolio-weighted basis
- Weighted-average carbon intensity measures a portfolio’s exposure to carbon-intensive companies on a position-weighted carbon exposure
- Carbon-intensity weighted for each position within a portfolio
What are the four types of exclusion based investing?
○ Universal -> based on global norms and conventions
○ Conduct-related
○ Faith-based
- Idiosyncratic exclusion
What are the implications of exclusionary investment on portfolio management and performance?
○ High potential tracking error
○ Active share
○ Skewness
○ Unintended factor exposure
- Challenge with synthetic assets (like currencies, commodity futures)
What are problems with fundamental analysis in portfolio management?
- Fundamental investor focus on bottom-up research focusing on single security coupled with engagement
- But while single-security studies often frame the investment process with a powerful engagement story, their anecdotal nature does not describe performance attribution from ESG exposure at a portfolio level.
- Portfolio analytics typically provide performance analytics that describe regional, sectoral, and stock specific performance attribution over a given time period
Why should ESG be integrated in the asset allocation process?
- Strategic asset allocation accounts for as much as 90 % of the variability of investment returns
- Traditionally, asset managers have managed systemic, macro-economic fa if asset manager believes that ESG represents a top-down risk, it needs to be considered in the capital allocation processctors by coupling allocation strategies alongside asset/liability management (ALM)
- if asset manager believes that ESG represents a top-down risk, it needs to be considered in the capital allocation process
What is the difference between dynamic and strategic asset allocation?
○ Dynamic asset allocation recalibrates on short-term basis using traditional factors to maintain mix
-Strategic allocation is only rebalances intermittently, is More aligned with ESG integration, but brings diversification trade-offs
What is the Black Litterman asset allocation model?
- more intuitive
- Anchored in general equilibrium market and not in requiring return estimates for asset classes
- Better suited for dealing with climate risk
How should climate impact on portfolios be modelled?
- Climate change modelling and literature review
- Risk factors and scenarios
- Asset sensitivity of different asset classes and industry sectors
- Portfolio implications
What should be considered in chosing an asset manager that can help with ESG integration?
○ ESG Policy
○ Affiliation with investor initiative like PRI
○ Accountability in the form of a dedicated personal and committee oversight
○ Manner how ESG is integrated into the investment process
○ Ownership and stewardship activities
- Client reporting capabilities
How should be process of selecting asset managers look like?
SEAO
a. Sourcing -> Maintain view on “best practice” , Seek to identify market leaders
b. Evaluation -> Include ESG questions in initial meeting, Investment philosophy, strategy, process, team structure
c. Approval -> Proprietary ESG scoring included in the manager tear sheet, ESG noted in due diligence check list, ESG policy reviewed, will not invest if Manager
Approval Group determines that material and relevant ESG risk cannot be sufficiently understood or qualified
d. Ongoing monitoring -> Maintaining of ESG score, operational due diligence, ESG added to heat maps
What are the challenges of integrating ESG in bond portfolio assessment?
- Bond issued represents multiple risk profiles across bond issuances
- There are ESG ratings for individual issuers, and there are ESG ratings for the bond, allowing for risk sensitivity resulting from ESG risk as a function of bond features
What are problems of applying ESG integration into sovereign debt?
○ Small investable universe
○ Exclusion of countries will further reduce number of invesment options
- CRA are important, and ratings are highly correlated
- Key is governance
Why is it hard to integrate ESG into private equity portfolios?
Lack of cumpolsory financial reporting
What are the two aims of integrating ESG into portfolio management?
RMAG
○ Risk mitigation
- Alpha generation
What does risk mitigation in the context of ESG integrated portfolio management mean?
○ Risk mitigation is the exercise of assessing and minimizing the exposure of a portfolio to ESG risk
○ In an ESG context, tail risk are generally long-term in nature and described as move by several standard deviations
○ Volatility may carry significant implications for portfolios overall risk profile and return
○ Correlating ESG integration and portfolio return is hard -> Performance attribution for ESG doesn’t commercially exists
What is the difference between idiosyncratic and systemic risk?
Idiosyncratic risk -> Firm or stock specific risk. In order to reduce or mitigate idiosyncratic risk, the portfolio manager may diversify the portfolio by either decreasing share or devesting
Systemic risk -> Represents market risk, which cannot be resolved through diversification alone
What can investors do to integrate ESG to generate investment returns?
○ An active quantitative approach to embed ESG into portfolios is to weight ESG as an idiosyncratic factor in a multi-factor selection
○ Portfolio managers use two approaches to decomposing performance attribution
§ Brinson attribution -> it decomposes
performance returns based on a portfolio’s
active weights /stock-specific attribution
§ Risk factor attribution -> Combines fundamental
risk factors (value, yield, growth, quality,
volatility) with ESG risks
What are the differences between absolute and negative screening for portfolio management?
○ Screening on an absolute basis will automatically attribute low ESG scores to certain industries or sector that are e.g. highly exposed to carbon emissions
○ This approach allows an investor to run sensitivity analyses against ESG-related shocks, like a carbon price, to test the resilience and correlation of a portfolio
○ However, the absolute basis approach potentially sacrifices the benefit of balanced portfolio relative to market of benchmark index
○ ESG screening premised on relative and peer-group datasets provides better context for building and maintaining balanced and diversified portfolio
What is portfolio optimization, and how does it differ from exclusionary investment?
- Portfolio optimization -> allows portfolio manager to target specific ESG rating or environmental objectives , while simultaneously minimizing tracking error
- 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
○ ESG optimization via constraints distinguishes itself from exclusionary screening in that it doesn’t apply a fixed decision on a specific security
○ Rather, it is organizing the securities by their individual ESG profile to solve a specific ESG optimization at the portfolio level
Environmental data good for portfolio optimization
- It is important to understand that targeted exposure that requires tighter constrains may likely result in an increase in deviation from an optimal portfolio
- Portfolios that optimize for multiple factors - particularly mixture between absolute data and sector-relative data - may have to accept a higher active risk
What is ESG integration?
- ESG integration is the systematic and explicit integration of material ESG factors into investment analysis and investment decisions
What is full ESG integration?
- Investing with a systematic and explicit inclusion of ESG risks and opportunities in investment analysis
- Circular process of financial and ESG analysis and iterative engagement activities which together lead to valuation of a company
- Combine fundamental analysis and tactics (including engagement) + quantitative methods
What is often overlooked in exclusionary investment?
Stewardship and engagement
What is passive investment and how can ESG be integrated? WHat are the three main techniques and what are its advantages and disadvantages?
- Passive investment means simplicity, rules-based approach based on indices and benchmarks
- Tilting based on ESG factors has limited or no exclusion or tracking error
- Weighting uses tilting but is designed to deliver specific ESG outcomes, but limited or no exclusions
- Exclusionary approach increases tracking error, but also improves ESG score the most
What are macro-economic climate considerations
- Asset class sensitivity to interest rates
- Heterogeneity and wide-ranging risk return profile
- Ability to add low or inverse correlation relative to market returns
What is the main driver of 90% of investment returns?
Strategic Asset Allocation
Exciting but little-developed reserah on how ESG integration can shape SAA decision making process
What is the correct definition of tail risk when it comes to ESG?
Tail risks are:
- LONG-TERM in nature
- Describes a significant change or move by several standard deviations in risk profile of an asset
What are examples of Strategic Asset Allocation models?
Strategic Asset Allocation (SAA) models include:
- Mean-variance optimization (MVO)
- Factor risk allocation
- Total portfolio analysis (TPA)
- Dynamic Asset Allocation (DAA)
- Liability-driven asset allocation
- Regime switching models
Which factor is the most material ESG factor for institutional investors to address?
Climate risk / Climate change
- Both SYSTEMIC and LOCAL
- Threatens financial system and global means of production as much as it poses risk on more localized level for specific regions, sectors, companies
- Potential physical risks will manifest in both acute, event-driven forms (extreme weather) along with longer-term, chronic shifts driven by effects of elevated temps and rising sea levels
What is the main focus for Multi-Manager strategies?
- Building PLATFORM of strong individual managers
What are the reasons ESG ratings and indicators are lower for emerging markets compared to developed economies?
1) Transparency
2) Rule of law
3) Regulatory authority
4) Anti-corruption
What are two macro-economic climate considerations for an equity portfolio with regards to Strategic Asset Allocation & Asset-Liability Management? (SAA & ALM)?
1) HEDGE AGAINST INFLATION (as a result from supply shocks and high govt spending)
2) SENSITIVE TO GROWTH / Macro-economic performance
What is an unintended negative consequence of negative screening?
Unintended Concentration Effect
What are some challenges of company disclosure on ESG topics?
- ESG disclosure remains voluntary
- Management discretion on what to report
- Management might report only issues they deem material
- Can be cultural differences on which issues are material, which ones are not
- Some companies exposed to # of ESG risks will report more on them, compared to company exposed to different set of ESG risks
- # of analysts diminishes on sell-side research as market cap of company decreaes
Why are ‘passive ESG’ funds more active than they may be marketed?
- ESG screening is sourced from third-party ESG datasets, which are based on their own underlying selection methodology
- Can confuse the market with differing and opaque integration approaches to ESG data
What is the GRESB?
Global Real Estate Standards Board
GRESB ESG benchmark leverages GRESB’s position as leading investor initiative focused on real assets and infrastructure with focus on commercial and residential real estate
What are TWO considerations for FIXED-INCOME portfolio with regards to Strategic Asset Allocation (SAA) and Asset-Liability Management (ALM)?
1) Sensitive to INTEREST RATE changes
2) LESS VOLATILE returns
What did the Quakers screen out in the 18th century?
Boycott SLAVERY and SLAVE TRADE
What is a challenge of SCREENING in PRIVATE MARKETs?
Screening can be employed in private markets.. BUT
DATA:
- Comparability of data is a challenge.
- Capability to compare investee company against cross-sectional competitor data or wider industry & sector data is often less robut because lower degrees of disclosure & reporting
What are the challenges behind FULL ESG integration?
- Depends on deep-rooted, often PROPRIETARY research
- Lacks easily-understable optics that high, blended ESG ptl score or low carbon exposrue that ‘Best-in-Class’ approaches provide
What are the challenges behind FULL ESG integration?
- Depends on deep-rooted, often PROPRIETARY research
- Lacks easily-understable optics that high, blended ESG ptl score or low carbon exposrue that ‘Best-in-Class’ approaches provide
Why do FULL ESG integration strategies do to address challenges?
- Evidence internal and external research resources
- Document how ESG is embedded, typically in a process slide
- Track and report on engagement activites with company management
- Include portfolio exposure and weightings into sustainability themes like the SDGs
- Provide positive impact measurements of the portfolio against metrics like resource efficiency, water and energy compution
- support the process with investment case studies
What is a negative consequence of negative screening?
GREATER SKEWNESS (tilts overall assets mix to higher than mean ESG rating; hurts diversification efforts)
What approach is most common for DISCRETIONARY ESG strategies?
FUNDAMENTAL, BOTTOM-UP appraoch alonside considerations of ESG factors
Compared to equity investors, fixed-income investors view balance sheet strength as:
MORE MATERIAL than equity investors
How does Dynamic Asset Allocation work? (DAA)
DAA is driven by CHANGES IN RISK TOLERANCE
- target date funds
- goal-oriented
What is PAII
Paris Aligned Investment Initiative
- Launched in 2019 by IIGCC (Institional Investors Group on Climate Change)
- PAII is European asset owner-coordinated and led intiative
- Works to develop methodologies and assessment tools related to aligning investment portfolios to Paris Agreement
- Includes work on Net Zero Investment Framework; which defines element of net zero strategy
- Offers recommended actions and approaches to measure and align ptls towards net zeo carbon
Four ESG Integration approaches
- EXCLUSIONARY (Negative)
- POSITIVE ALIGNMENT or BEST-IN-CLASS (Positive screening)
- THEMATIC Investing
- IMPACT Investing
What is most appropriate definition of ESG optimization?
ESG OPTIMIZATION VS CONSTRAINST distinguishes itself from exclusionary screening:
- Does not apply a fixed decision
- Organizes securities by individual eSG profile to solve for a specific ESG optimization at the OVERALL PORTFOLIO level
What is appropriate definition of TAIL RISK for ESG context?
Risks that are long-term in nature and describe SEVERAL STD DEVIATION movement in risk profile of an asset
Tails are long-term in nature
Potential volatility of asset may carry significant implications for portfolio’s overall risk profile and potential risk-adjusted returns
Two types of risk
Idiosyncratic & Systematic
Idiosyncratic: firm or stock-specific risk
Systematic: market-risk (like recession)
How to avoid long-term climate risk affects on credit issuer?
Invest in shorter-dated maturing debt
What is Regime Switching Model?
- Models abrupt and persistent changes ni financial variables due to shifts in regulations, policies, and other secular changes. Captures fat tails, skewness, and time-varying correlations
What is LDI / Liablity-Driven Investing?
- Seeks to find most efficient asset class mix driven by fund’s liabilities
Concerned with: - Return of assets
- Change in value of liabilities
- How assets and liabilities interact to determine overall portfolio value
What is MVO / Mean-Variance Optimization
- Constructs efficient frontier that represents mix of assets that produce minimum standard deviation (as proxy for risk) for max level of expected return
- Based on defined asset class buckets & long-term expected returns, risks, correlations
What are key indicators considered by WORLD BANK for SOVEREIGN DEBT investors?
- Political stability
- Voice and accountability
- Government effectiveness
- Rule of Law
- Regulatory quality
- Control of corruption
Challenges related to ESG Datasets?
ESG datasets are poor because:
- Lack of history
- Lack of completion (breadth)
- Lack of comparability
- Lack of regulation / auditing
According to LGT Capital Partners, Development of ESG capabilities among managers over 7 yr period has shown
Increase of managers scoring GOOD and EXCELLENT
Between ‘13 and ‘19, # of managers scoring EXCELLENT and GOOD went from 4% to 15%
Four key areas to assess ESG for MANAGER SELECTION (Blackrock, Evaluation stage)
Four key areas of ESG Integration for Manager:
- Investment Philosophy
- Investment Strategy
- Investment Process
- Team structure
What indices might analyst use to assign Financial Stability Score (FSS) when assessing SOCIAL CAPITAL strength?
- Life expectancy index
- Education index
- Human Development index
What does FTSE Russell Index track?
- Equity index
- 4000 securities in developed and emerging countries
- 300 ESG indicators
- Measures companies’ revenue exposure and mgmt to green and brown (fossil fuel) exposure
What are the four categories of EXCLUSIONS?
FUCI
- Universal
- Conduct-related
- Faith-based
- Idiosyncratic exclusions
How does carbon exposure relate to leverage / weight of investment?
Carbon exposure measured as:
CARBON INTENSITY x RELATIVE WEIGHT OF INVESTMENT
What is BRINSON ATTRIBUTION?
Approach to decomposing performance attribution
BRINSON decomposes performance returns based on portfolio’s ACTIVE WEIGHTS
Generally represents performance returns attributed to:
- REGIONAL
- SECTOR
- STOCK SPECIFIC
Two types of attribution models that Insitutional Investors apply?
BRINSON ATTRIBUTION
RISK-FACTOR ATTRIBUTION
Types of ESG Investing for FIXED-INCOME
- Green Bonds
- Social Bonds
- Sustainability Bonds
- Sustainability-linked Bonds
- Transition Bonds
- SDG-linked Bonds
- Blue Bonds
What are advantages of REAL ASSETS with regards to ESG integration?
- Investors tend to be MAJORITY OWNERS or
- OWN ASSET OUTRIGHT
- Offers investors greater control over the definition, application, and reporting of ESG data alongside or outside existing reporting standards like that of GRI (Global Reporting Initiative)
What are challenges of BEST-IN-CLASS approach?
- Diversity of ESG rating methodologies
- Lack of ratings convergence
- Should be tested on transparency as well as consistency
What are key criteria under DNSH principle in Technical Expert GRoup Final Report on EU Taxonomy?
- Guidelines that include economic activities that make a substantial environmental contribution to climate change mitigation or adaption (but not cause significant harm to designated environmental objectives:
- SUSTAINABLE USE and PROTECTION of water and marine resources
- Transition to CIRCULAR ECONOMY, waste prevention, recycling
- POLLUTION PREVENTION and control
- PROTECTION OF HEALTHY ECOSYSTEMS
What is a shortcoming of evidence of ESG’s performance-enhancing impact?
SELECTION BIAS
Current evidence often in form of single-security or single-asset case studies
What is a key advantage of BLACK-LITTERMAN MODEL (BLM) asset allocation?
BLM does NOT REQUIRE estimates for each asset class
- starts from global investment universe as input, so no requirement of assumption of RETURN, RISK, CORRELATIONS
How are fixed-income securities ranked by levels of ESG integration?
Greater number of higher ratings in:
- INVT GRADE CREDIT
- EMERGING MARKET DEBT
- BUY-AND-MAINTAIN strategies
Lower integrations:
- GOVERNMENT DEBT
- HIGH-YIELD CREDIT
What are the KEY FACTORS to the ‘story’ for a FUNDAMENTAL ANALYST?
Key factors for a fundamental analyst:
- Intrinsic value of the security
- Credit analysis
- Potential for rerating or derating in valuation
- Potential risks
- Short-term and long-term catalysts
- Expectation on security’s earnings growth and cash flow profile
What are key metrics of due diligence for MANAGER SELECTION for ESG?
- The existence of an ESG policy
- Affiliation with investor initiatives, such as the 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
- Client reporting capabilities
What asset class has seen lowest integration of ESG?
HEDGE FUNDS
then
Fixed-income (Low/medium)
Public Equity (Medium/high)
Infrastructure (High)
What are some exclusions from Shariah law?
- Conventional banking and insurance
- Pork and non-Halal foods
- Alcohol
- Gambling
- Tobacco
- Adult entertainment
- Synthetic instruments like derivatives and swaps
- Weapons
What is Transition Pathway Initiative? (TPI)
TPI Dataset and tool use forward-looking carbon metrics to MEASURE and DETERMINE companies’ pathways relative to three benchmark scenarios defined by Paris Agreement
Companies are measured in two ways:
1) Quality of companies’ governance and management of GHG
2) Carbon emissions relative to international targets and national commitments as defined by Paris Agreement
- Developed in partnership with GRANTHAM RESEARCH INSTITUTE ON CLIMATE CHANGE & ENVIRONMENT, London School of Economics
- 2017
What are some globally-recognized frameworks for SCREENING
- UN Global Compact
- UN Human Rights Declaration
- ILO’s Declaration on Fundamental Principles and Rights at Work
- Kyoto Protocol
- Organization for Economic Co-operation and Development (OECED) Guidelines for Multi-National Enterprises
