Chapter 8: Integrated Portfolio Construction

Question 1

What defines exclusion based investment?

Answer 1

Negative screening, prioritizes norms, non-engagement,

Question 2

What defines ESG investing?

Answer 2

Positive screening, prioritizes measurability, reinforce engagement, reporting

Question 3

What defines Impact investing?

Answer 3

Prioritizes intentionality and additionality, framework-orientated, impact-focused, measurable outcomes

Question 4

In what areas should ESG integration at the porfolio level be active?

Answer 4

○ Portfolio exposure
○ Risk management
○ Performance and attribution
○ Asset allocation decisions

Question 5

What should be included in the investment thesis that an security analyst develops?

Answer 5

○ 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

Question 6

What is the task of a portfolio analysis and what are key challenges?

Answer 6

• 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

Question 7

What are parts of a ESG integration framework for portfolios?

Answer 7

○ 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

Question 8

What characterizes a discretionary portfolio investment?

Answer 8

○ 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

Question 9

What characterizes a quantitaitve portofolio investment strategy?

Answer 9

○ 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

Question 10

What the TCFD recommendations for integrated portfolio management ?

Answer 10

• 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

Question 11

What is the carbon-weighted portfolio exposure calculated?

Answer 11

• 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

Question 12

What are the four types of exclusion based investing?

Answer 12

○ Universal -> based on global norms and conventions
○ Conduct-related
○ Faith-based
- Idiosyncratic exclusion

Question 13

What are the implication of exlcusion investment on portfolio management and performance?

Answer 13

○ High potential tracking error 
○ Active share
○ Skewness
○ Unintended factor exposure 
- Challenge with synthetic assets (like currencies, commodity futures)

Question 14

What are problems with fundamental analysis in portfolio management?

Answer 14

• 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

Question 15

Why should ESG be integrated in the asset allocation process?

Answer 15

• 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

Question 16

What is the difference between dynamic and strategic asset allocation?

Answer 16

○ 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

Question 17

What is the Black Litterman asset allocation model?

Answer 17

• more intuitive
• Anchored in general equilibrium market and not in requiring return estimates for asset classes
• Better suited for dealing with climate risk

Question 18

How should climate impact on portfolios be modelled?

Answer 18

1. Climate change modelling and literature review
2. Risk factors and scenarios
3. Asset sensitivity of different asset classes and industry sectors
4. Portfolio implications

Question 19

What should be considered in chosing an asset manager that can help with ESG integration?

Answer 19

○ 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

Question 20

How should be process of selecting asset managers look like?

Answer 20

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

Question 21

What are the challenges of integrating ESG in bond portfolio assessment?

Answer 21

• 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

Question 22

What are problems of applying ESG integration into sovereign debt?

Answer 22

○ Small investable universe
○ Exclusion of countries will further reduce number of invesment options
- CRA are important, and ratings are highly correlated
- Key is governance

Question 23

Why is it hard to integrate ESG into private equity portfolios?

Answer 23

Lack of cumpolsory financial reporting

Question 24

What are the two aims of integrating ESG into portfolio management?

Answer 24

○ Risk mitigation

• Alpha generation

Question 25

What does risk mitigation in the context of ESG integrated portfolio management mean?

Answer 25

○ 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

Question 26

What is the difference between ideosyncratic and systemic risk?

Answer 26

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

Systematic risk -> Represent market risk, which cannot be resolved through diversification alone

Question 27

What can investors do to integrate ESG to generate investment returns?

Answer 27

○ 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

Question 28

What are the differencens between absolute and negative screening for portfolio management?

Answer 28

○ 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

Question 29

What is portfolio optimisation, and how does it differ from exclusionary investment?

Answer 29

• 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

Question 30

What is ESG integration?

Answer 30

• ESG integration is the systematic and explicit integration of material ESG factors into investment analysis and investment decisions

Question 31

What is full ESG integration?

Answer 31

• 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

Question 32

What is often overlooked in exclusionary investment?

Answer 32

Stewardship and engagement

Question 33

What is passive investment and how can ESG be integrated? WHat are the three main techniques and what are its advantages and disadvantages?

Answer 33

• Passive investment means simplicity, rules-based approach based on indices and benchmarks
  1. Tilting based on ESG factors has limited or no exclusion or tracking error
  2. Weighting uses tilting but is designed to deliver specific ESG outcomes, but limited or no exclusions
  3. Exclusionary approach increases tracking error, but also improves ESG score the most

Question 34

What are macro-economic climate consideration

Answer 34

• Asset class sensitivity to interest rates
• Heterogeneity and wide-ranging risk return profile
• Ability to add low or inverse correlation relative to market returns