Portfolio customisation and investment selection are ways to integrate sustainability in asset portfolios as equity investors seek to respond to the challenge of net zero by 2050.
Wilma de Groot, head of core quant equities at US$100 billion ($150 billion) Dutch fund manager Robeco, said the one size fits all approach of many investors may not be suitable in the move to decarbonise asset portfolios.
“If you want to integrate sustainability into your portfolios, it means moving away from this [standardised] default,” she said at the Investment Magazine Equities Summit in Sydney last month.
“We see investors that are making this change and really aim for a more customised portfolio but [for] the majority of investors, currently still focus on a light touch of customisation as stability of returns takes priority.”
Choosing the right investments and selection metrics is another key factor to help investors embed sustainability in portfolios.
Robeco’s research showed the value premium between companies with high carbon emissions and those with medium to low carbon emissions was not substantially different. She explained this meant the firm could set the selection metric higher for high carbon value stocks to enter their portfolio that resulted in lower carbon emissions compared to a more generic value strategy. This is one of the ways to achieve both high expected returns and strong sustainability integration.
Active ownership through voting and company engagement on environmental and social issues is another way investors can ensure underlying portfolio assets are aligned to their sustainability targets. “Most of the asset managers vote against these proposals, so it is important for investors to assess managers on their voting behaviour,” said de Groot.
“But I think it’s equally important to make sure that this stewardship approach is actively reflected in portfolio positioning. To really make sure that if an engagement is unsuccessful that you can actually also exit that [investment].”
De Groot said many sustainability challenges are intertwined. “It is becoming a very complex world with regulators pushing asset owners toward standardised indices, while sustainability is pushed aside.”
“However, investors can co-create with managers a portfolio of choice that allows investors to select required risk budget, steering on sustainability dimensions of choice and even steering on their own selected sustainable development goals. This can be done periodically, for example, when beliefs or objectives change.”
Performance test constraints
The Your Future, Your Super performance test has tracking error implications for the decarbonisation of portfolios, impacting investment behaviour.
“There is a need to acknowledge the tension between the risk budget that’s available to super funds in the context of the new Your Future, Your Super performance test, and the tracking error implications of decarbonisation in a portfolio,” said Ole Moerk, senior portfolio manager at DWS, which has €833 billion ($1.3 trillion) of assets under management.
“Depending on your past track record, and where you sit with respect to the performance test, you might have limited budget of risk that you are able to allocate towards any active strategy and any benchmark deviation, especially towards ESG topics like decarbonisation.”
Fiona Mann, head of equities and ESG at Brighter Super, confirmed the super fund converted several equities portfolios to passive due to the impact of the performance test. “[It] was really distressing as an ESG person, because we had all these stocks that we wouldn’t have had previously under some of our active strategies.”
One of the ways to contain tracking error and lower the carbon intensity of equity portfolios is to manipulate the weights in your portfolio to drive down the carbon profile, explained DWS’s Moerk. The average carbon dioxide emission level of the MSCI All Country ex Australia index shows that the carbon exposure over the last five years has dropped mainly because the weight to the technology sector rose and the weight to sectors likes energy, materials and utilities fell.
“It really shows you that the carbon profile of the index is much more driven by the weights of the constituents than the decarbonisation of the companies themselves,” he said.
Asset owners have a choice of investment strategies depending on how well they come up in the performance test. These include an index strategy with a Paris-aligned benchmark, a systematic strategy where portfolio managers have the skill set to deploy a limited risk budget towards a set of outcomes – and an active strategy with higher alphas targets and higher tracking error levels.
“For those that are fortunate and had very good performance in the last few years, they’ve got a bit more room to explore different avenues and look into various different strategies,” said Moerk.
“But some are incredibly close to failing the performance test, which is really not an option because it is business critical for funds to pass the test. They probably have fewer options and need to go somewhere within the space of passive.”
Manager selection is also vital said Brighter Super’s Mann. “We make sure that every single manager in our portfolio is absolutely best in class at ESG integration. Each has their own strength like environmental, diversity and inclusion. It’s almost like putting together a portfolio with value and growth, quality and all those other things as an overlay on top of the portfolios.”