Can You Fit ESG Investment Goals in Your Portfolio?

This blog is the first of a three-part series where we delve into an implementation framework to help you:

1) establish ESG investing goals,

2) uncover managers that align
with your preferences, and

3) measure the outcomes that you expect.

The steady buildup of environmental, social and governance (ESG) investing in the past few years can make even the most skeptical investors wonder if they’re missing out on an opportunity.

The rise in sustainable investing has driven investors, who are agents on behalf of beneficiaries or clients, to evaluate whether they need to engage in ESG investing — it’s often subjective and ambiguous and yet a proposition that needs to be carefully assessed.

ESG is not a single asset class, factor or strategy, and it’s not the same for every asset owner or, for that matter, every asset manager. There’s no universal approach to adopting ESG issues into your investment objective, but the best place to start is with your goals.

We suggest that there are three interrelated perspectives when considering ESG implementation.

• Doing Well: risk-adjusted return objectives
• Doing Good: non-financial goals
• Biding Time: time horizon

These preferences may have important interactions to consider, we use a three-dimensional octant cube to illustrate them (Figure 1). To establish your goals, we recommend understanding potential tradeoffs, if any, and determining where your organization fits along these dimensions.

Balancing Preferences

ESG investing goals will differ by investor and may create compromises that require significant judgment, especially if non-financial preferences have political or religious considerations. It’s important that you adopt criteria that balance the requirements of your stakeholders: beneficiaries, sponsors, regulators, investment staff, leadership teams and others (e.g., donors). Doing so helps ensure clear expectations once you’ve made the decision to implement ESG, or not.

Start at Home

An easy place to start understanding this model is with your location. Different regulatory environments may dictate your latitude for satisfying certain preferences. For example, the U.S. Department of Labor’s (DOL) guidance on ESG investing is clear for certain retirement plans: fiduciaries must focus on the economic interest of plan beneficiaries and be careful not to put too much weight into ESG considerations, in cases of tension. In fact, this specific example offers us a great reference point as we guide you clockwise through the two dimensions of this model.

Doing Well and Doing Good

DOL guidance might persuade some U.S. retirement plans to focus on Maximizing Investment Preferences. This goal might devalue or disregard ESG considerations. Yet, as we pointed out in a previous Intech paper, it’s increasingly practical to include moderate ESG considerations in portfolio construction without negatively affecting performance.

“…it’s increasingly practical to include moderate ESG considerations in portfolio construction without negatively affecting performance.”

Therefore, the potential for Harmonizing Total Preferences of “Doing Well” and “Doing Good” may exist using one or more ESG investing methods. Your specific degree of synergy depends on how you balance stakeholder needs or requirements; indeed, investors in other regulatory settings (e.g., Europe, Australia, U.S. non-ERISA plans, etc.) may seek to place more weight on ESG criteria.

Maximizing Non-Financial Preferences focuses on the goal that the utility gained from achieving non-financial objectives offsets any potential performance shortfalls. An acute example may be a portfolio guided solely by religious principles.

Finally, some institutions are Targeting a Non-Financial Theme. These goals are less common. They may be narrower in scope and implemented through private markets. For instance, a manager might contribute profits to cancer research and try to attract capital from other investors.

Is Time on Your Side?

So far, we’ve ignored the “Biding Time” dimension to ease explanation, but understanding time horizons for “Doing Well” and “Doing Good” is essential. Investment preferences and non-financial preferences demonstrate impact over a variety of time horizons. Asset owners, their constituents and their asset managers must have compatible views about time horizons to set expectations appropriately (Figure 2).

Investors may have to bide their time to realize the non-performance benefits of ESG investing. ESG investing benefits can have a long, and often uncertain, time horizon. For example, an impact from climate change might take 10 years to materialize and you have to reconcile this ambiguity with more certain time horizons like benefit payouts or reward systems. If you base your reward system on three- or five-year performance, you may lose confidence in an underperforming ESG strategy even if it has better long-term potential.

In other cases, realizing benefits might take less time. For instance, if your goal relies only on a simple negative screen, you can directly validate portfolio holdings quite easily. And, of course, applying ESG performance attribution allows you to evaluate performance for such a strategy over shorter periods.

These three dimensions – “Doing Well,” “Doing Good” and “Biding Time” – offer context for establishing your organizations’ ESG investing goals. But, importantly, it also helps you assess the ESG investing methodologies most appropriate for your organization.

Uncover Managers that Fit Your Goals

This blog post on ESG implementation is the first of a three-part series helping you 1) establish ESG investing goals, 2) uncover managers that align with your preferences, and 3) measure the outcomes that you expect. For the complete implementation guide, download our most recent paper, “What to Look for on the Road to ESG.”