Since the emergence of “Modern Portfolio Theory” and the “Capital Asset Pricing Model” in the late 1960s, institutional investors have taken a quantitatively driven approach to portfolio construction, looking to create portfolio diversification and obtain better risk-adjusted returns by balancing their asset-class exposures. This journey has seen several important advancements in thinking about how to optimally achieve desired results.
Funds that want to take the total portfolio approach first need to get the total portfolio view. To do that they not only need data – and lots of it – but a rock-solid understanding of exactly how they’re going to use it.
Don’t get keyed up on BFID – it won’t hurt ESG
One of the more obtuse changes under Your Future Your Super (YFYS) was the insertion of the word “financial” into “best (financial) interests’ duty”. While the introduction of BFID was received with some bemusement from funds – they were under the impression that they already were managing money in the best financial interests of their members – there was also concern that it would prevent them pursuing ESG strategies for fear that they would be perceived as making ideological investments.
But Jennifer Sireklove, Parametric managing director for investment strategy, says that funds shouldn’t let a change in terminology change how they invest.
“If you read deeper beneath it, the basic intent and concept of fiduciary duty and the way that you think about investment outcomes hasn’t changed, even though the wording has changed,” Sireklove said. “There’s sometimes some hand wringing or trepidation depending on the wording, but there’s actually more consistency in what you’re trying to achieve all along regardless of some of the subtleties of the wordings that come up.”
Sireklove notes that the same changes have already occurred in the US. In 2015, the language was “very encouraging” for ESG, with the Department of Labour (DOL) saying that “ESG factors can be an integral part of portfolio construction.” In 2018, under the Trump Administration, the DOL took a more cautionary tone – and by 2020 it was warning that the investment decisions of pension funds must only be based on “pecuniary factors.” But Sireklove says that for many investors, the changes in language didn’t radically change their investment approach.
“It became a bit more cautionary, and some felt very concerned – but again, if you thought all along you were looking at economically relevant issues and risk and return, it doesn’t change how you’re operating,” Sireklove said. “… I think for investors who are always looking at it through the lens of financial materiality and risk/return, those language changes didn’t radically shift anything.”
“Investors who are keyed up on this concept of companies that are good ESG or bad ESG are maybe more thrown by those (different regulatory) periods.”
Still, that protracted period of regulatory volatility where ESG was in and out might give some investors pause for thought. While the newly-elected Labor Government is expected to take a more encouraging approach to ESG investment, Hostplus CIO Sam Sicilia recently noted that funds can’t afford to get on the wrong side of politics, saying that the “opposition of today is the government of tomorrow.”
“It does create a little bit of caution,” Sireklove said. “I think ideally – and this is from the US perspective – that creates a discipline around that decision making and how you document it and how you evaluate it after the fact …I think there are ways of coping with that uncertainty, but there are likely some plans and decision makers who are more reticent to go through that because they might not feel they have the coping mechanisms to be on the right side of it.”
Sireklove says that in Parametric’s experience, funds can improve their ESG characteristics without materially altering expected returns in a way that might attract the attention of government or regulators. And while the constraints of YFYS have made funds wary of making big bets that could come back to bite them, a team of researchers – including Sireklove – previously found that emissions reductions through ESG screening or integration were possible without taking on more than 50 basis points of tracking error.
“When considering these two portfolio construction techniques, how far funds are willing to venture above or below these levels will depend on their willingness to trade off risk for ESG outcomes,” Sireklove wrote in January.
“The capability to constrain risk through portfolio optimisation in particular may prove a powerful tool for funds navigating the YFYS performance test. In an integration approach, optimisation affords finer risk controls, meaning risk budgets can increase to accelerate ESG outcomes or tighten to stay within the limits of the performance test.”
