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How ESG Investments Impact Portfolio Construction

Starting the journey is a challenge – but the rubber meets the road around risk and return.

How ESG Investments Impacts Portfolio Construction

How ESG Investments Impacts Portfolio Construction

For many institutional investors, ESG is still an area filled with question marks and potential. ESG is an investment driver that once engaged with permeates the investment process all the way through portfolio construction. When investors begin their exploration of ESG, they often find that just getting started is a serious challenge.

“For many investors, ESG is a journey that starts with something small and builds up to a fully integrated solution,” says Jessica Hart, Retirement Lead, Outsourced Solutions, Northern Trust Asset Management. “It’s not at all uncommon for us to hear baseline questions, such as ‘What do I do?’ and ‘How do we get started?’

“We begin to address their interest by asking about their priorities, what they want to achieve, and how they want to measure progress and success,” Hart continues. “Our goal is to build those objectives into an investment policy statement and help create an investment framework over time.”

How those goals and objectives affect portfolio construction is no small matter. Not too many years ago, negative screening was the primary tool used in ESG portfolio construction. Negative screening was a simple enough approach and perhaps an obvious starting point, but now it’s typically just one aspect of sophisticated ESG strategies.

“It has been genuinely interesting to watch the entire investment industry shift in a very short time span in the context of investment strategies built with mostly longish time horizons in mind,” says Chris Vella, CIO, Multi-Manager Solutions, Northern Trust Asset Management. “From negative screening we’ve already moved on to considering positive factors and third-party vendors, for example, to better identify important ESG factors in active strategies. We’re at the point now where asset managers are developing and using proprietary data teased out of corporate information to build an ESG strategy with the potential to perform well.”

1. The risk and return question around ESG

By far, the single highest hurdle in portfolio construction linked to sustainable strategies is the question around risk and return.

“Risk and return implications for integrating ESG into your portfolio is the big one,” says Michael Hunstad, PhD, Head of Quantitative Strategies, Northern Trust Asset Management. “Whether you consider equities or fixed income, one of the things that we have learned over the last decade is that when properly applied ESG does not negatively impact the performance or risk of a portfolio. In fact, it could be additive from a risk perspective.”

In fact, says Hunstad, it’s one of the rare occasions when investors can have their cake and eat it, too.

“Both in passive and in active strategies, when you control sector biases, country biases, and currency biases that result from ESG tilt or exposure, you can actually still create alpha,” he says. “It’s hard to do because it requires a keen awareness of the risk you’re taking from an ESG perspective, but you can in fact apply ESG to alpha generating strategies.”

Tucked into what Hunstad says about risk and return is some nuance around the perception investors have of ESG. Some view it as a risk mitigator, others as a return driver.

“Perhaps the most important thing to remember when incorporating ESG into the portfolio construction process is that in and of itself ESG is not an asset class,” says Hart. “It’s not a return driver, it’s not a risk mitigator – it’s all those things because it’s a framework that should be arch across the entire portfolio, including equities and bonds. Every portion of the portfolio should consider ESG factors to drive long-term risk and return. ESG shouldn’t be carved out as its own section of the portfolio. Doing so is likely not aligned with an institution’s commitment to ESG investing being applied across the asset pool.”

Of course, the investible companies that go into an ESG investment strategy underlie all conversations around related portfolio construction. That’s one reason why Northern Trust Asset Management has created a proprietary ESG scoring methodology called the ESG Vector Score, which assesses publicly traded companies on financially relevant ESG-related criteria that could impact operating performance.

“Ultimately, sustainability is about how well companies are managed,” says Julie Moret, Global Head of Sustainable Investing and Stewardship, Northern Trust Asset Management. “Part of what the ESG Vector Score looks at is how a company’s board is structured – its principles and policies – and whether they are properly enacted by management throughout the organization. It also encompasses how a company manages its environmental externalities and its human capital. The point is that ESG information provides a measure of sustainable performance. Companies that successfully measure against these parameters are often companies that have a longer strategic vision that can result in value creation, increased brand equity, and ultimately add to investment performance.”

2. Manager red flags

One area of concern for investors new to ESG is greenwashing – essentially, a marketing ploy used by some businesses, including some asset managers, to make investments seem much more sustainable than a closer examination would reveal to be true. Not surprisingly, regulators in Europe have taken the lead in raising awareness and combatting greenwashing, with their peers in the U.S. just starting to make some significant inroads.

“In the world of asset managers, we’ve gone from an environment where it wasn’t uncommon to embellish a couple of slides to much more care being taken that marketing material is accurate,” says Vella. “But investors still need to be careful about how investible corporations represent themselves, and how thorough portfolio managers are at implementing and executing authentic ESG strategies rather than conducting a box-checking exercise.”

More broadly, Vella says investors should be aware of red flags beyond greenwashing. He sees the landscape in terms of a barbell. At one end is large asset managers who take ESG quite seriously at a corporate level, investing a lot of resources into it, including technology. The danger at this end of the barbell is at the execution/portfolio manager level. “You want to keep an eye on the engagement level,” says Vella. “Does it match what the company is saying at the highest levels? If you’re not seeing the same level of interaction or engagement from the portfolio manager, it should be taken as a warning sign.”

The other end of the barbell is an investment team at a smaller manager that is committed to ESG investing and has developed a phenomenal process around it. “In that scenario,” says Vella, “you want to be sure they are getting the support they need to execute. And that support should be evident from the most senior levels of the firm.”

As a manager of $155 billion in ESG assets*, Northern Trust Asset Management is engaged in ESG from top to bottom as a global firm, and the company embodies the best of both ends of the barbell described by Vella without the downsides.

“The importance of ESG from an organizational perspective is infused throughout senior management and makes its way to every team across the organization,” says Vella. “Our Quantitative Equity Team and Quantitative Fixed Income Team, for example, have done a phenomenal job taking ESG factors to the next level, creating the ESG Vector Score and other ESG-related innovations that are unique in the industry today. And all of that is being executed on every day for our clients.”

For additional insights from Northern Trust Asset Management, please click here.

*Assets under management as of 7/30/21

Northern Trust Asset Management (“NTAM”) is composed of Northern Trust Investments, Inc. Northern Trust Global Investments Limited, Northern Trust Fund Managers (Ireland) Limited, Northern Trust Global Investments Japan, K.K, NT Global Advisors, Inc., 50 South Capital Advisors, LLC, Belvedere Advisors LLC and investment personnel of The Northern Trust Company of Hong Kong Limited and The Northern Trust Company.

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