Understanding risk and reward in an ESG portfolio

The challenge is that while a proliferation of new responsible investment funds have come to market, the evolution is not at the point where an adviser can know the attitude to risk of a fund manager, in the way they can, for example, by looking at the allocation to the highest risk bonds in a bond fund. 

Shaunak Mazumder, global equity fund manager at Legal & General Investment Management, says advisers can use standard measures of risk, such as examining the portion of small caps relative to large caps in a fund, and the level of diversification of a fund, as a way to understand the risk level. 

He says: “Just as with a regular portfolio, the less risk you take, the lower the returns will be. And if you buy companies which trade at high multiples, then the likelihood is that returns in future will be lower than if you buy a lower rated company.”

This view is echoed by Yuko Takano, global equity fund manager at Newton Investment Management, who works on a portfolio of four funds with different risk profiles.

She says the risk level of each fund can be viewed in a similar way to that of a non-ESG fund, with the analysis of the riskiness of a stock carried out in the same way as in a non-ESG portfolio, and with all of the stocks in all of the portfolios compliant with ESG principles. 

Angus Parker, who runs the HSBC Global Equity Climate Change fund, says the key to risk management within such a portfolio is to ensure that the client is not overly exposed to any one theme, government policy, region, or individual equity. 

For Sarah Norris, investment director at Aberdeen Standard Investments, the market has moved beyond the point where those investing in sustainable investment funds are required to sacrifice some returns, and, instead, sustainable investors are those more likely to offer protection against future risks.

She says a key part of an ESG investor’s role is to identify future economic and political trends, and understand how these will impact portfolios in future.

Norris says companies that have a strategy for investing sustainably are likely to be more in tune with changing consumer habits and regulatory issues.

Chris Iggo, chief investment officer, core investments at Axa Investment Managers, says the regulatory duty of an asset manager is still to think about risk in the financial sense, and says his approach is generally to create portfolios based on an initial investment scenario, such as having bonds with a short date to maturity, and then add the ESG analysis on top of that. 

In that precise scenario, he says the outcome would be that the bonds which get into the portfolio would have an even shorter date to maturity as a result of ESG concerns. 

More risk considerations

Jennifer Anderson, co-head of sustainable investing and ESG at Lazard Asset Management, says the duty of money managers in the future will be to broaden the number and types of risks considered when making an investment, adding the risk of negative outcomes from ESG impacts on society to the list.

She says: “Where in the past, ESG issues were addressed primarily through restrictions and guidelines, investors now increasingly see that these questions are more nuanced and need to be addressed more thoughtfully. By integrating a more comprehensive set of ESG considerations into our process, and by recognising the linkages between returns on financial capital and how companies manage their human and natural capital, we believe we are able to better deliver attractive risk-adjusted returns on behalf of our clients.

"We strive to build portfolios that are well diversified and that deliver the most attractive risk-adjusted returns for our clients. Of course, we recognise that the opportunity set for sustainable investing looks different across regions and investment styles and that the thresholds for inclusion in a sustainable portfolio can therefore vary accordingly.”

Iggo says there is a material risk that by, for example, investing in oil companies, one could end up owning “stranded assets”, that is, assets that are worth a negative amount on the balance sheet, and so drag down the returns available to shareholders, and this is a risk that might not be captured by examining traditional investment risk questions alone. He says this is particularly the case as investor priorities change over time, creating a new set of risks.  

Martijn Kleinbussink, portfolio manager on the Kempen sustainable equity team, says: “Investors should caution against getting overly excited about the sustainable opportunity and forgetting the financial return.

"This is why we focus primarily on quality in our analysis. We want to invest in the transition to a sustainable economy, not subsidise it. We look for high-quality industries that are undergoing a sustainable change.

“Secondly, we look for the companies within a high-quality industry that are well positioned for sustainable change. Finally, we undertake an extensive valuation exercise to assess the potential returns of investing in a sustainable opportunity. Only when all of these factors align, do we invest. In this way we ensure that we will not only take care of the sustainable returns, but also our client’s required financial returns.”

Paul Niven, head of multi-asset portfolio management at BMO Global Asset Management, says: "In a low interest rate world and one where the outlook for company earnings is uncertain, sourcing attractive and reliable sources of yield is a challenge.

"Keeping diversification to the fore of our thinking helps a mindset that allows us to search out income opportunities and manage risks. A key focus for us is the sustainability of income, especially in the context of ensuring that we don’t erode our clients' savings by chasing high, but ultimately unsustainable, yields or investing in companies that pay a high dividend but make a loss in terms of their share price performance.

"We maintain a key focus on total return and believe that, in the current environment, a yield of around 4 per cent is achievable while also maintaining scope for growing capital over time."

David Thorpe is special projects editor at FTAdviser