Why it's important to consider ESG in asset allocation

Pendal

August 2022

ESG is not just a company-level issue, says Pendal multi-asset portfolio manager ALAN POLLEY

• Asset allocation accounts for about 90% of a portfolio's return variability
• Important to consider ESG at asset allocation level
• Find out about Pendal's multi asset funds

ENVIRONMENTAL, social and governance factors should be incorporated into portfolios at an asset allocation level - rather than only at individual stock selection level, says Pendal's Alan Polley.

ESG has long been a critical factor in investing, aiming to identify and avoid risk and financial loss as well as bring about change.

But it's often considered only at a company level.

A better investing framework would incorporate ESG factors at an asset allocation level before the security selection process even takes place, says Polley, a portfolio manager in Pendal's multi-asset team.

"We know asset allocation is the primary driver of investment returns. It explains about 90 per cent of the return variability in a portfolio according to the original Brinson study," says Polley.

"But ESG integration in asset allocation is not something that is covered in the industry.

That's for two reasons:

"First, because it's hard. How do you think about it?

"And second, in my opinion, asset allocation is not well shaped in the industry overall.

So, where does ESG fit into an investment process that isn't very well defined?"

Three-part framework

Polley offers a three-part framework for thinking about ESG in asset allocation.

The practice of asset allocation fundamentally involves three decisions, he says:

• Changing allocations between existing asset classes
• Changing the definition of existing asset classes
• Introducing new asset classes

"When you think about asset allocation, you really doing one of those three things - there's no other decisions.

"Given those three decisions sets, incorporating ESG is quite simple."

Climate change example

Polley uses the environmental factor of carbon emissions as an example.

"Emissions intensity in Australia is vastly higher than global markets. So, if you think climate change is an important investment consideration, you might tilt away from Australian equities towards international developed markets.

"There is a ESG headwind to the Australian market and the Australian economy in its exposure to fossil fuels."

Pendal's multi-asset funds have incorporated this insight by reducing a portfolio's home bias and tilting instead towards US and European shares.

The framework also holds true for social and governance factors.

"Emerging markets are not great on E, S or G - they are emerging for a reason. But we're not going to rule out the asset class because it's an important source of diversification and returns.

"So, we changed the definition - for emerging markets, we've removed repressive regimes: China, Saudi Arabia, Russia and a few others. From an ESG standpoint, we just don't think they're true to label."

The change means the portfolios can still hold emerging markets assets and lifts the weightings to less risky markets.

New asset classes

The third asset allocation decision - introducing new asset classes - has allowed the portfolios to lift exposure to the energy transition theme.

"The conversion from fossil fuels to renewables is a secular tailwind so we have created a listed renewables infrastructure asset class. We're investing directly into renewable listed investment companies - the underlying assets are pure infrastructure like batteries, wind farms, solar and hydro.

"It's great because we tend to focus on investing in primary market stock issuances, so we're directly funding the development of these renewables assets.

"It's a great way of getting a big lick of ESG exposure into our portfolios within the asset allocation construct."

It's important that sustainable investors step beyond simple security selection, says Polley.

"Security selection is just the first generation of ESG thinking - the 1G.

"Asset allocation is 2G and you can even step up to a third generation and consider ESG in the whole of portfolio construction.

"But most of the industry is still stuck at 1G."

Author: Alan Polley, Portfolio Manager

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