The challenges of constructing a sustainable multi-asset portfolio

Pioch says: “When it comes to sustainable investing, diversification, cost and suitability are the three things we never talk about.

"The average client certainly doesn’t want a portfolio that is too concentrated. And in this climate that is certainly a risk because some parts of the market have become seriously overvalued. Investments in decarbonisation, for example, performed very well last year.”

Government bonds tend to go into multi-asset portfolios as a diversifier, but many clients have an issue with them on ethical grounds that many governments have armies Will McIntosh Whyte, Rathbones

But he says the task of building a diversified sustainable investment portfolio has become a lot easier in recent years, as more companies disclose information about their environmental, social and governance priorities and achievements. 

Will McIntosh Whyte, multi-asset investor at Rathbones, says: “At the headline level there is no difference between ESG, multi-asset and the rest.

"There is a complication around the role of government bonds; they tend to go into multi-asset portfolios as a diversifier, but many clients have an issue with them on ethical grounds that many governments have armies.

"We tend to buy gilts in portfolios, but wouldn’t, when Donald Trump was president, buy US government bonds in sustainable portfolios as the country pulled out of climate agreements. It might change now that Trump is gone.” 

Government bonds are often a feature of multi-asset portfolios as a diversifier, the expectation being they will perform inversely to equities, and so provide diversification in times of market strife. 

They performed this role during the heavy sell-off of equities in 2020. 

Kristina Church, head of sustainable solutions at Lombard Odier, says that not all government bonds should be treated equally, and one can “rank” governments by other factors, such as commitment to climate change goals, and take the view the bonds of those countries are more sustainable than those of countries that have less clear policies in those areas. 

Simon Holmes, multi-asset investor at BMO Global Asset Management, says: “I think you have to own some government bonds for diversification. It's also very difficult to find high-yield bonds or emerging market bonds that are sustainable, but with developed market government bonds you can look at factors such as corruption levels and transparency levels of a government.

"But I think you have to have some government bonds or you are too far away from providing a suitable product for the risk appetite of many clients.”

Risk and volatility 

James Saunders, head of portfolio management at Tatton Investment Management, says: “Risk within a portfolio is often managed through holdings in less 'risky' bonds, so any investor needs to be comfortable with the type of ballast they hold within portfolios.

"Within ESG portfolios long-dated government bonds may need to be replaced with high-grade corporate paper and cash, which could in turn limit your ability to allocate to higher yielding bond assets as this combination may not provide as much downside protection as a traditional government-bond-heavy allocation.”

Holmes says the allocation to equity in portfolios is the main determinant of risk level, something that he feels does not change when sustainable investment criteria are added to a portfolio’s mandate. 

Craig Mackenzie, manager of the Aberdeen Standard Multi-Asset Climate Solutions fund, says: “The reality is that with an ESG portfolio, or any other portfolio, you get the risk associated with the asset class; the challenge in the sustainable investment market is if you buy a very concentrated portfolio, like a renewable energy exchange-traded fund, you end up with something that is very volatile – that product went up 60 per cent last year, but is down a lot this year.

"It has proved to be much more volatile than equities are, about one and half times more volatile than equities, and shows the risk of being overly concentrated.” 

One of the major challenges of constructing an equity portfolio with sustainable investment criteria in mind is that many of the businesses that are sustainable fit into the 'growth equity' camp, rather than the 'value equity' one, and so leave investors exposed to only one type of market. 

Rathbones' McIntosh Whyte says: “I think if you have the whole of global equities to work with you can find a balance of growth and value stocks, but you definitely have to work harder to do it. You can’t really find any sustainable stocks within areas such as financials, which are a major part of the value universe, but industrial companies are interesting and many of those are sustainable – the universe is certainly improving.”  

Holmes says that: “Realistically you are going to have to have a tilt to growth stocks, but one way to have value is to look at the minerals which go into renewable products, as those would perform in a more cyclical way, like value stocks.” 

James Sullivan, head of partnerships at Tyndall, says that if one “unbundles” the different components of ESG investing, it becomes easier to diversify. By viewing companies as complying with one or two of those criteria, if not yet the third, the options for portfolio diversification become broader. 

Chris Hiorns, head of multi-asset strategies at EdenTree Investment Management, says while there is a risk when building a sustainable equity allocation that one ends up concentrated in areas such as clean energy and technology, one alternative is to buy infrastructure assets, which tend to be sustainable.   

Tatton's Saunders says the picture will evolve over time, with many areas of the market that are presently considered both growth and ESG compliant right now likely to be regarded as value stocks at periods of time in future. 

David Thorpe is special projects editor at FTAdviser