Sustainability ESG A Fundamental Reshaping of Finance

ESG Considerations for Asset Allocation

February 04, 2021

A Fundamental Reshaping of Finance: A Frostbyte Thought Leadership Series

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 the investment industry’s process for asset allocation and considerations for ESG. Asset allocation is relevant for both individual and institutional clients. Integrating ESG criteria into the asset allocation process is one of the most important trends in asset management and is integral for investors with a long-time horizon [2].

Overview of Asset Allocation

Asset allocation begins with the development of a governance process. The investment governance process will typically start with managers understanding the client’s investment objectives in both the short and long-term. The process will lay out the responsibilities for all parties, specify the process for creating an investment policy statement (IPS) as well as a process for asset allocation and rebalancing. The governance process will also seek to apply a framework to monitor goals and objectives. In some cases, the governance policy itself will be audited by and independent third-party.

Investment objectives can be categorized into one of three approaches: asset-only, liability-relative, or goals-based investing. Asset only investing does not explicitly model liabilities or goals that clients may have but will seek to maximize returns for an acceptable level of risk. Asset only investing is commonly used by foundations, endowments, sovereign wealth funds, and individual investors. Liability relative investing seeks to fund a client liability and invest excess assets for growth. Some of the characteristics of liabilities that should be considered include the nature (fixed or contingent), duration, convexity, the size of the liability compared to the size of the sponsoring organization, factors affecting future cash flows, and regulations that could impact future value. Approaches to liability-relative asset allocation include surplus optimization, hedging/return-seeking portfolios, and integrated asset-liability portfolios. A liability relative approach is most common for banks, defined benefit pensions and insurers. Goals based investing on the other hand is most commonly applied to individual investors and has the objectives of achieving goals with a required probability of success. ESG factors can be integrated into any of these allocation approaches, with individual investors often focusing on making investments that have a positive impact while institutional investors will consider ESG from a risk management perspective.

As investment managers look to specify asset classes, they will seek market risk across factors that are homogenous, mutually exclusive, have low correlations, cover all possible investable assets, and have sufficient liquidity. In traditional asset allocation, there are four asset classes including global public equity, global private equity, global fixed income, and real assets. In non-traditional asset allocation, factors are used. These factors provide risk exposure across different axioms and can include, for example, inflation, volatility, credit, and duration risk. ESG-related factors could also be used to gain exposure to companies with low carbon emissions intensity or high gender diversity. ESG-integration can also be incorporated into a risk budgeting framework. This can occur at the strategic asset allocation level or at the level of individual asset classes. Often investors will have competing priorities between risk and return. Risk budgeting identifies the total amount of risk and allocates risk to different asset classes. The goal is to maximize return per unit of risk. Mathematically, the level of risk taking is optimal when the excess return per “marginal contribution of total risk” is the same for all assets in the portfolio. The marginal contribution of total risk is equal to the beta or market risk factor multiplied by the standard deviation of returns. The concept of risk budgeting can be extended to ESG-investing. A “sustainability budget”, which measures the percentage of capital in the portfolio that is allocated to sustainable assets, can allow asset owners to manage the somewhat competing priorities of risk and return [3].

Principles for Asset Allocation

In traditional asset allocation, a commonly used technique is mean-variance optimization (MVO). MVO identifies portfolio allocations that maximizes returns given a set of investable assets, the pairwise correlations of the assets, and the assets’ expected risk and returns. These inputs allow the investment manager to determine the optimal point on the efficient frontier that maximizes the investor utility. The key ESG-related input into the MVO process would be in defining the set of investable assets. For example, some investors may have a preference to exclude businesses where the core revenue generating activities are related to tobacco, alcohol, weapons, or gambling. Others may incorporate ESG at the asset class level and exclude stock and bond indices that do not meet certain ESG disclosure and performance criteria.

The MVO process has its limitations. Criticisms include the fact that the process is heavily dependent on the input data, the process can result in concentration across asset classes, and the failure to incorporate risk diversification. Other criticisms include MVO’s inability to incorporate skewness and kurtosis, its failure to incorporate serial correlations as a single-period framework, and its categorization as an asset only strategy. Clearly there are improvements that can be made. The quality of the inputs is one of the key constraints and these can be improved through one of four ways: 1) using reverse optimization (where expected returns are a model output and assumed optimal asset allocations are a model input); 2) applying the Black-Litterman model (which is similar to reverse optimization but incorporates investors views on equilibrium returns); 3) adding more constraints; and 4) resampling MVO by combining MVO with Monte Carlo approaches to seek more efficient and consistent optimization. With respect to improvement number three, adding more constraints, this could include an investor’s ESG-related preferences.

Monte Carlo simulation (MCS) can be used to bolster the robustness of an asset allocation. Compared to MVO, MCS is not a single period model and therefore is more adept at incorporating rebalancing, trading costs, and tax implications across time. MCS can also better model non-normal distributions, serial and cross-sectional correlations, evolving asset allocations, path dependent decisions, non-traditional investments, and human capital. Perhaps most importantly, MCS can guide an investors risk tolerance as it provides a realistic picture of potential future return outcomes. This can be important for setting investor expectations for ESG-related investments. In some instances, investors may sacrifice yield for social and environmental impact. Understanding the return implications upfront for an allocation will help to ensure the investors do not deviate from their investment policy statement during times of market turbulence.

Asset Allocation in Practice

Asset allocation preferences may be constrained by the investment size, liquidity, or time-horizon. Let’s start with discussing investment size. Large investors have an advantage in that they can pursue more diverse and complex strategies. Large investors are also more likely to possess more advanced skills, have better governance, and greater efficiency. The downside with large investors is that it may be difficult to pursue niche strategies given liquidity or trading cost constraints. Liquidity constraints can be particularly relevant during times of market stress. Small investors on the other hand may be more nimble and able to pursue niche investment opportunities, but there may be minimum investment constraints that limit their ability to participate in private equity, real estate, hedge funds, and infrastructure investments. Small investors may also have staff constraints on monitoring investments and lack the ability to fully diversify across asset classes.

While investment time-horizons are not always related to investor size, typically smaller, individual investors have more dynamic time-horizons given changes to goals, liabilities, and human capital over the lifetime of an individual. If investors can take a longer time horizon, they are able to diversify risk across time and therefore take on investments that offer a higher rate of return. For example, investments in low-carbon energy are infamous for their long-time horizon. Technology must make its way from the lab bench to the field and then to commercial-scale deployment. In these cases, patient capital is needed. Outsized returns could be earned for these types of investments, and they offer tremendous potential for advancing global energy sustainability, but a long investment time horizon is a necessity.

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.