Achieving a diverse portfolio

Supported by
Royal London Asset Management
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Supported by
Royal London Asset Management
Achieving a diverse portfolio
Pexels/Rachel Claire

First, it is important to stress that ESG portfolio construction does not mean reinventing the wheel and Dan Kemp, chief investment officer, Emea, at Morningstar Investment Management, stresses that the same disciplines apply.  

“You have to remember ESG investment is still investment,” says Mr Kemp. “All the same rules apply – it’s really important that portfolio managers and advisers don’t forget that.  

“Having said that, you cannot use the same assumptions as the assets may be more concentrated. For example, a strict socially responsible investment approach would exclude a large proportion of the market, which means you end up with less diversification.” 

It’s quite difficult to build an ESG portfolio in the same way as a traditional portfolio Dan Kemp, Morningstar

Lee Robertson, co-founder and managing director of Octo Members, agrees and says the issue of ESG diversification is more about the state of the investment industry than the theory of portfolio construction itself.  

“Personally I don’t think there’s a massive difference and you can balance ESG and diversification pretty equally now,” explains Mr Robertson, “at least on face value, because most fund groups will be publishing their ESG credentials on what ESG looks like for them.  

“However, not all fund groups are created equal [in regards to ESG] and there is the whole greenwashing issue. Asset managers are still on a journey.” 

Part of that journey includes fund launches and lots of them. At the very least, advisers curious about sustainability are not struggling for choice as asset managers are increasingly launching funds in this area as a way of competing.

Key Points

  • ESG has become very popular 
  • There are many choices available to investors
  • ESG ratings are one way of assessing a fund

For example, according to Morningstar data, in 2019 more than 360 sustainable funds were launched. More ESG funds to choose from has not made diversification any easier though.

“It’s quite difficult to build an ESG portfolio in the same way as a traditional portfolio,” Mr Kemp notes. “For example, there are fewer single asset funds available and a lot are multi-asset, or global.

“So when we launched our ESG portfolios in May 2019, we limited the platforms we operated on to those that were able to operate well with exchange traded funds. We believed the only way we could build a well-diversified ESG portfolio was to use ETFs, as that is where most of the single asset ETF innovation is happening.”

Desmond Fitzgerald, senior policy adviser at Pimfa, runs a CPD-accredited ESG academy for advisers, and says a client’s risk appetite can help inform diversification decisions, with the blending of active and passive vehicles potentially playing a key role. 

“Diversification is based on the requirements of the client, so in the context of ESG, are they looking for alpha or beta?” he says.

“Say a client wants a long-term and steady investment. Data is now more nuanced so you can create portfolios looking at beta, helping you pick a range of passive funds aiming for consistent returns. At the same time you might balance this out with active funds that give you a bit more of a push. It all comes back to the suitability of the client.”

Experienced ESG investor Rob Stewart, head of responsible investment research at Newton Investment Management, says he is now finding diversification opportunities in newer sectors where such factors almost come as standard.  

“There has been a massive push into the tech space, but one of the more interesting things is what is happening on the other side of this that might give us some diversification,” Mr Stewart points out. 

“This has led us to things like efficient infrastructure and electric vehicles. Sectors like this have growth, ESG characteristics and provide something different to the dominant theme that has been driving markets this year, thereby providing some diversification.” 

Crunch year for advisers and ESG 

ESG is not a new concept but it is increasingly becoming hard to ignore for IFAs.

On top of greater client demand – 85 per cent of advisers have seen more ESG queries from clients this year, according to Federated Hermes – new MiFID II rules mean they will soon have to start taking ESG into consideration. 

Unfortunately a disconnect exists between what is available, in terms of sustainable investments, and what can be easily accessed by the point of the adviser, which can get in the way of diversification. 

At West Financial Management, managing director Helen West’s ESG ambitions have been frustrated by platform and compliance issues. 

“We have been wanting to do this for some time but we are still not doing it as much as we’d like to be,” she says. 

“This is mainly because, from a compliance point of view, research is proving difficult. It isn’t easy for us to say we’re using one company over another, so the way we use research is holding us back.” 

At the same time, the other option facing Ms West – outsourcing to a discretionary fund manager experienced in ESG – is also proving difficult. 

“Simplification is an issue as you can’t always access the funds that you want on a certain platform, and a lot of our clients are elderly so I don’t really want two or three accounts on the go,” she adds.

In her case, Ms West would like to invest in LGT Vestra’s ethical managed portfolio service but cannot access this via her Old Mutual Wealth platform. And while she could invest in the latter’s ESG proposition, this lacks the level of diversification she wants for clients. 

This is part of the reason why Andrew Alexander, director and head of investments and product strategy at Three Counties, has not entertained the idea of sourcing an off-the-shelf ESG solution.

“You can go to a DFM, but with their fees they’re pretty much asking for your first born,” says Mr Alexander, who does not have an ESG offering, but acknowledges the upcoming regulatory pressure to do so. 

“That said, the options are pretty limited,” he adds. “There are ratings for ESG funds, but is it worth rating funds as a snapshot in time? Therefore, how stable is that rating?” 

Concentration risk 

Due to the difficulties around research, there is a risk of ESG ratings being relied upon at face value.

For example, oil giant Shell has a 59 per cent ESG ranking by sustainability research provider CSRHUB for its work on sustainability and cutting emissions. This rating belies the fact Shell is known to be a polluter.  

Mr Fitzgerald says this represents a learning curve for advisers as investors will need to do more thorough research in order to arrive at their own conclusions.

He notes: “The biggest challenge is the quality of data and the ability to analyse it properly.  

“Like with any funds, you don’t take the asset manager at their word when they say it’s the best thing since sliced bread. You read the prospectus and then do your own due diligence.” 

Jon Yarker is a freelance journalist