ESG Considerations for Equity – Portfolio Construction

One of the most significant events in sustainable finance came in 2020 when Larry Fink, the CEO of BlackRock, the largest asset manager in the world, called for a fundamental reshaping of finance. The reshaping that Larry had in mind was to put climate change and sustainability issues at the center of risk assessment and capital allocation. The letter is a clear warning to company CEOs: climate and sustainability risk is investment risk. As other investors come to this same realization, the implications for asset values and the reallocation of capital could be profound. Changes to capital markets could come much more quickly than the physical impacts for climate change itself given the propensity of capital markets to discount future risk today.

Considering climate and sustainability risk in your company’s capital allocation process is no longer optional. In fact, BlackRock has even gone as far as to state that they will vote against management and board directors of companies that are not sufficiently incorporating sustainability practices into business plans. BlackRock has stated that they expect that sustainability integration will ultimately result in lower investment risk and better market returns. In short, sustainability is the new standard for investing.

Given that companies will face increasing shareholder pressure to incorporate sustainability into capital allocation, enterprise risk management, and standard operating procedures, it is essential to understand the underlying investment drivers for asset managers and how they might consider environmental, social, and governance (ESG) or sustainability risk factors. Clearly, climate-related risk is the most material ESG risk for many industries and sectors, but health and safety, labor management, anti-corruption, and toxic environmental releases are also key issues that must not be overlooked ^[1].

In this thought-leadership series, we look to put you in the shoes of the asset manager. How are investment decisions made? What are the unique implications for various asset-classes? How do asset managers consider investment risk? How is traditional asset management balanced with ESG considerations? These are some of the questions that we hope to tackle. Our goal is to help companies better understand the asset manager process and prepare for the shifting expectations around sustainability integration and disclosure. Those companies that can navigate this fundamental reshaping in finance will be best positioned for growth as the economy transitions to a more sustainable, lower-carbon future.

Introduction

In this thought-leadership piece, we provide the reader with an overview of portfolio construction for active equity investing and its implications for ESG. We start by describing elements of a manager's investment philosophy and approaches for constructing actively managed equity portfolios. We then seek to distinguish between active share and active risk concepts and discuss how each measure relates to a manager's investment strategy. Next, we discuss the application of risk budgeting concepts and discuss risk measures in portfolio construction. This is followed by a description of how assets under management, position size, market liquidity, and portfolio turnover affect equity portfolio construction decisions. We then give an overview of active equity investing by discussing how the investor can evaluate the efficiency of a portfolio structure given its investment mandate. We conclude our overview of portfolio construction for active equity investing with a review of the long-only, long extension, long/short, and equitized market-neutral approaches to equity portfolio construction. We then shift from our overview of portfolio construction for active equity investing to discuss the implications for ESG investing.

Investment Philosophy and Portfolio Construction

We begin our overview with a description of the elements of a manager's investment philosophy that influence the portfolio construction process. Active return is an important concept to consider for the active equity investment manager. Active return is the return on a security multiplied by the difference between the portfolio weights and benchmark weights (also referred to as the active weight). Sources of active return include rewarded factors, alpha, and luck. The building blocks used in portfolio construction are slightly different than the sources of active return and include rewarded factor weights (i.e. beta), alpha skills (i.e. tactical exposure, and position sizing. Another relevant concept for the portfolio construction process is the fundamental law of active management which includes breadth of expertise. Breadth of expertise integrates each of the three sources of active return.

When constructing actively managed equity portfolios, approaches for implementation include systemic approaches (which are rules driven and based on the broad equity universe) and discretionary approaches (which are based on opinion and a smaller subset of securities). Security selection on the other hand can be divided into top-down and bottom-up investment approaches. Top-down approaches consider the macro environment and factor timing along country, asset class, sector, and security-level axioms. Bottom-up approaches consider individual securities. In all cases, portfolio construction is effectively and optimization problem with objectives (return goals) and constraints (risk avoidance goals).

Active Share and Active Risk

An investment manager will specify the acceptable levels of deviation from the benchmark and quantify this deviation in terms of active share and active risk. Active share is the degree to which the number and sizing of positions in portfolio differs from the benchmark. The metric takes a value between zero and one. If a manager holds a portfolio of stocks that are not in the benchmark, the active share is one. If they hold the benchmark weights in their portfolio, the active share of the portfolio will be zero. If two portfolios with the same benchmark invest only in benchmark securities, the portfolio with the fewer securities (and therefore higher degree of concentration in positions) will have a higher level of active share. Active share is commonly used by investors to assess the fees paid per unit of active management. Investors will prefer portfolios with a higher active share if fees are high.

Active risk, also known as tracking error, is the standard deviation of active return. The metric measures the volatility of portfolio returns relative to the volatility of the benchmark returns. Active risk is affected by the degree of cross-correlation between securities. If an investment manager underweights a health care stock in order to overweight another health care stock, the active share will increase, but the active risk may not. A concentrated stock picker will have a very high active share and active risk, while a pure indexer will have zero active share and active risk. A factor neutral investor will have low active risk and low active share (assuming they are diversified) while a factor diversified investor will have a reasonably low active risk and high active share as a result of the large amount of securities that a likely to be different from the benchmark.

Risk Budgeting and Risk Measures

Risk budgeting is the process by which the contribution to the total risk of a portfolio is allocated to the constituents of the portfolio in the most efficient manner. The contribution of a single asset to the absolute portfolio variance is determined by summing the product of each individual asset’s weight by the weight of all other assets in the portfolio and their pairwise covariance. This value is then divided by total portfolio variance to yield the portion of the variance attributable to the single asset. Portfolio variance can be attributed not only to assets within a portfolio, but also to sectors, countries, or pools of assets representing factors (like value and growth) in a similar manner.

Risk measures that are incorporated in equity portfolio construction can be heuristic or formal. Heuristic risk factors can limit concentration by security, sector, industry, or geography. They can also limit exposure to market factors such as beta, size, value, and momentum. Net exposure to currencies, degree of leverage, degree of illiquidity, and exposure to environmental or reputational risk are also considerations. Formal risk measures in contrast are statistical in nature. Statistical measures require an estimation of the return distribution. Statistical measures include volatility, active risk, skewness, drawdowns, and value at risk. Value at risk is defined as the minimum loss expected a certain percentage of the time over a given period. Cumulative, instantaneous, and marginal value at risk are all relevant concepts that the investment manager must consider.

Drivers of Equity Portfolio Construction Decisions and Efficiency Evaluation

Portfolio management costs can be explicit or implicit. Implicit costs are related to price movements and include slippage costs, which are high for small-cap firms during periods of high market volatility. Implicit costs also include market impact costs, which are higher with immediate execution of a trade. Market impact costs can be large when assets under management are high, when there is higher turnover and a short investment time horizon, when trades have high information content, and when securities are small-cap and less liquid. These factors all affect the equity portfolio construction decision.

When the investment manager is looking to evaluate the efficiency of a portfolio structure, they will seek alignment with features of a well-constructed portfolio. A well-constructed portfolio delivers characteristics promised to the investor in a cost and risk efficient way. Key features of a well-constructed portfolio include:

1. it has a clear philosophy and consistent process;
2. it delivers risk and structural characteristics as promised;
3. it achieves desired risk exposure and a risk efficient delivery method; and
4. it has low operating costs given a strategy as set out in the investment mandate.

The Long-only, Long Extension, Long/short, and Equitized Market-neutral Approaches

We wrap up our overview of active equity investing portfolio construction by discussing the long-only, long extension, long/short, and equitized market-neutral approaches to equity portfolio construction. The long-only approach to equity portfolio construction differs from a long short portfolio. Given these two options, the investment manager’s choice is a compromise between:

1. the reduction risk and the capture of the full market risk premium;
2. expanding the return potential from alpha and other premiums versus active risk; and
3. diversification versus higher cost and complexity.

There are two long/short portfolio construction approaches. The first is the long extension portfolio which guarantees the investor 100% net exposure with a specified short exposure (and the potential for significant leverage). The second long/short portfolio construction approach is the market neutral strategy. This involves removing market exposure by offsetting long and short positions, often by entering into a pairs trade.

The choice of portfolio construction approach must ultimately consider capacity, scalability, legal liability, regulatory complexity, costs, and the personal ideology of both the investor and the asset manager. That being said, there are distinct benefits of a long/short strategy including the ability to express negative views, the ability to gear into high conviction longs, the ability to remove market risk, and the ability to control risk factor exposure. Drawbacks of long/short strategies include the potential for large losses because of negative exposure to the market risk premium, the high amount of leverage that may be needed, the cost of borrowing securities, collateral demands from prime brokers, and the fact that short positions can be subject to a short squeeze.

Implications for ESG Investing

Having covered some of the foundational concepts of equity portfolio construction, we now turn our attention to ESG and sustainable investment considerations. When an investment manager considers portfolio construction, they may consider separating alpha and beta to make investment portfolios more efficient. As you will recall from the discussion above, these represent two of the three fund building blocks used in portfolio construction (the third being position sizing). There is a strong belief held by ESG-focused investors that sustainability is a source of alpha - at least in the long-term. Research by Neuberger Berman ^[2] suggests that rewarded factors are not only limited to beta. They identify five premia from global developed and emerging market equities: value, size, quality and momentum. They also identify an insurance premia that can be extracted through put-option-writing strategies. They suggest that this can deliver additional diversification, alpha, and higher risk-adjusted returns.

Research by Alumdi ^[3] provides insights on how the investment manager can use ESG ratings for equities and bonds. Interestingly, they find that if the overall consistency between ESG ratings and over- or underweighting in the portfolios are important, then the portfolio with the highest ESG rating is not necessarily the most socially responsible. They use this finding to support the conclusion that investors may achieve full compliance with socially responsible investing rules, at the cost of reasonable tracking error, without showing any significant difference in relative performance versus a standard market benchmark portfolio. Clearly this analysis would depend on the underlying securities having an ESG rating that is representative of their true sustainability risk exposure. This underscores why it is vital that the sustainability managers publish ESG metrics that are complete, accurate and verified by and independent third-party.

Conclusion

As we look to put you in the shoes of the asset manager, our hope is you will gain a deeper understanding of ESG integration and the investment management process. The companies that understand the asset manager’s decision-making rationale for incorporating sustainability and climate-related risk are likely to be the most responsive to changing investor requirements and trends. As global efforts are made to transition the economy to a more sustainable, lower-carbon future, we expect that investor demands for sustainability performance and disclosure are set for significant growth. Companies should begin to prepare today in order to meet investor expectations in the future. This will require having the right infrastructure for collecting sustainability-related data, understanding performance, reporting on key indicators, and setting targets to improve. Ultimately, companies that can master this core competency will gain more shareholder interest and will be poised for superior performance. Now is the time to seize the opportunity in the shift to sustainable investment.

References

1. https://www.msci.com/www/blog-posts/which-esg-issues-mattered-most/01934601065
2. https://www.nb.com/en/global/insights/equity-portfolio-construction-filling-the-gap-between-alpha-and-beta
3. https://research-center.amundi.com/page/Publications/Discussion-Paper/2014/SRI-and-performance-impact-of-ESG-criteria-in-equity-and-bond-management-processes

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