Diversifying your responsible investment portfolio

Does ESG limit portfolio diversification?

A persistent issue for many of those who seek to create sustainable investment portfolios is the relative lack of diversification.

On the surface at least, many of the equities that form the cornerstone of the investment universe are long-duration assets, in areas such as electric vehicles or clean energy, and so are vulnerable during periods where shorter duration assets are in vogue.

Such periods tend to coincide with times of higher inflation and rising interest rates, such as we saw in 2022.

And because bonds tend to react in the same way, the traditional inverse correlation between the asset classes may not apply in the responsible investing universe.

But given the style factors at play, what does diversification mean?

The level of interest in ESG investing has grown rapidly, and the investment universe has expanded to meet this need, says Mariella Rice-Jones, a responsible investment analyst at Brooks Macdonald.

“There are still some asset classes that are more difficult to get exposure to, but there are well-diversified ESG portfolios available,” Rice-Jones says. “Adopting a broad definition of sustainability is key to building a diversified ESG portfolio.

“By not only considering pure play ‘green’ companies or companies that already have minimal ESG footprints, but also companies that are transitioning, as well as those outperforming peers across ESG pillars, portfolios can be exposed to a range of sectors, geographies and investment styles.”

7IM’s head of ESG portfolio management, Jack Turner, says the hope is that the ‘shrinking’ of the investable universe will lead to better economic outcomes over time.

At Columbia Threadneedle Investments, multi-asset portfolio manager Simon Holmes says its approach to sustainable investing can reduce the investable universe by up to approximately 40 per cent, but that a large number of companies remain to build a portfolio.

“Our overall approach to sustainable investment within the Sustainable Universal MAP range is built upon three key pillars: avoid; invest; improve. Adopting the approaches encompassed by both ‘avoid’ and ‘invest’ can have an effect in reducing the available universe of investable companies.”

Under the avoid approach, Holmes says that weapons, tobacco and fossil fuels are excluded from the Sustainable Universal MAP range. This can reduce the universe, as represented by the MSCI World index, by 15 per cent to 20 per cent.

The ‘invest’ approach identifies companies that are aligned with a sustainable future or will “assist on the journey to that future state”, which Holmes says can be in areas such as renewable energy, technology, industrials and healthcare.

“We believe that there is a large and growing range of opportunities available to the sustainable investor, as the impetus grows to tackle the social and environmental challenges facing the world today,” he adds.

“As a starting point when looking at the opportunity set, we classify companies with at least 50 per cent net positive revenue alignment with the UN sustainable development goals as sustainable.

“Typically, this can exclude roughly 40 per cent of the universe as represented by the MSCI World index, which, while not insignificant, still provides a large number of companies from which to build a sustainable portfolio.”

Besides company-level exclusions, the types of investments available could also limit a sustainable investor’s options.

Some of the areas that are more difficult for ESG investors to access still include absolute return funds, and perhaps some of the more esoteric investments such as private equity, says EQ Investors’ head of fund research, Victoria Hasler.

But she also says that the universe of funds catering to clients with various ESG requirements is continually growing, which has made it easier to build diversified portfolios.

Diversifying within a sustainable investment universe

Allocations to equities and bonds of 60/40 or 80/20, for example, are typically viewed as the default point for portfolio construction and the building blocks of a diversified portfolio.

And broadly speaking, the approach to asset allocation for a sustainable and traditional fund should be very similar, as the asset mix typically determines the expected risk and return, says Eloise Robinson, a multi-asset associate analyst at Columbia Threadneedle Investments.

But she adds that it is important to be aware of the bond sensitivity of a sustainable equity portfolio.

“A typical sustainable equity strategy with a growth and quality bias may include a higher sensitivity to bond yields than a traditional strategy,” says Robinson. “We aim to mitigate this through diversifying across several equity strategies with a range of style exposures.”

Hasler at EQ Investors likewise says that the primary risks of equities and bonds classed as ‘ESG’ tend to be very similar to those of traditional securities, although there are some nuances that investors should be aware of.

“For example, when buying responsible or impact global equity funds, we have found that these tend to have a bias towards Europe over the US. This should be easily accounted for in portfolio construction.

“We have also found that many sustainable funds have a bias towards smaller companies compared to their benchmarks. This makes sense as smaller companies often tend to be more innovative in areas such as sustainability.

“Again, however, this is something of which investors should be cognisant and adjust for in the portfolio construction process if they do not want to tolerate the mismatch in risk between their portfolio and a broad market index.”

In addition to bonds and equities, sustainability can be a source of diversification.

When it comes to diversifying sustainability themes, Turner at 7IM says investors need to assess the factors that are driving each one.

How do the underlying companies derive their earnings? Have they got strong cash flows? Have they got a moat? What margins do they earn? These metrics will help them understand how correlated each theme is, Turner says.

“You could build a portfolio with themes that include clean energy, circular economy, digitalisation and biotech, and think they are diversified. However, many of the stocks in these themes will have a strong growth bias, and will underperform in a rising rate environment.”

What role can fixed income play?

In the case of ESG bonds, Robert Fullerton, a senior research analyst at Hawksmoor Investment Management, says an issue in the fixed income market is that many of the world's biggest bond issuers – the example he cites is energy companies – would fail an ESG screen.

He said this creates a problem of diversification within the fixed income allocations of responsible bond investors.

“This leaves a lot of ESG corporate bond funds more reliant on financial services for their sector allocations, and often end up somewhere between 40 per cent and 80 per cent financials,” Fullerton says.

Turner at 7IM similarly says that when talking about ESG bonds, it is important to distinguish between labelled bonds, such as green or social bonds, and those that are issued by more generalist ESG leaders.

Labelled bonds, he adds, will generally have slightly lower yields than a ‘normal’ bond, also known as a green premium or ‘greenium.’

“This is a benefit for companies as they can issue green bonds at a lower cost than ‘normal’ bonds,” says Turner. “The premium appears as more investors demand the positive characteristics of a green bond, driving the price up and the yield down.

“While this is a positive for companies that are trying to raise money for green projects, it can be abused and lead to greenwashing. That is why firms are encouraged to follow guidelines like ICMA’s Green Bond Principles when issuing these bonds.”

Andrew Brown, director and fund manager – credit at Columbia Threadneedle Investments, says that any greenium depends on the asset class and sector.

“For those sectors that have been at the forefront of issuance such as supranationals where there has been significant supply, there is limited green premium. Within corporates the same can be said for sectors such as utilities that have the greatest issuance.

“More and more corporates are coming to the market and from different sectors, and you certainly do see more of a premium from new sectors or issuers as investors seek diversification.

“For labelled bonds, generally we would say sustainability-linked bonds are still treated with a little scepticism by many investors, and attract the least premium.”

As for ESG equity funds meanwhile, many tend to have a bias towards new-world technologies and industries, says Iboss investment manager Chris Rush. “From a style perspective, these industries tend to be more growth-oriented.

“Many of these companies have performed well over extended periods, but recent years have demonstrated the importance of ensuring diversification within your equity allocation. Therefore, looking under the bonnet of the equity funds is necessary to ensure that they invest in different regions, industries and sectors.”

Holmes agrees that because of exclusion criteria and a targeted opportunity set, sustainability-focused equity strategies can generally have inherent biases away from, for example, excluded sectors such as tobacco, weapons and fossil fuels, and towards technology and healthcare and away from yield and value, and towards more growth and quality factors.

“In the years immediately prior to 2021, this emphasis provided a positive tailwind, as interest rates remained low and the Covid pandemic saw strong performance from growth sectors such as technology.

“However, that reversed in 2022 when higher inflation and rising interest rates saw markets rotate. Growth was soon out of favour and value saw a return to the fore.

“In June 2022 we added a new sustainable equity income strategy to the Sustainable Universal MAP portfolios. It provides an income stream from dividends, which over the long term can be a useful component of total return.

“Importantly, it also serves to provide a broader style dynamic to the equity mix, which thereby reduces our reliance on quality and growth factors. Given styles tend to come in and out of favour, a diversified style profile reduces reliance upon one specific regime for returns.”

Others agree that sustainable investing for income is achievable.

“Investments in wind farms and solar farms tend to generate most of the returns in the form of income and typically pay good dividend yields,” says Rob Harrison, head of research at Progeny Asset Management.

"The alternative for clients is to invest in green or ESG bonds that, at their current level, generate mid to high single digits of income.”

Rice-Jones at Brooks Macdonald also cites exposure to renewable infrastructure assets, as well as real estate investment trusts that invest in green properties, affordable housing and healthcare facilities, which she says typically offer a steady stream of income from rent or lease payments.

While investing for growth and/or income is a common consideration when picking investments, any sustainability preferences will add another factor to consider.

When assessing whether a portfolio matches a client’s sustainability preferences, Rice-Jones notes the importance of looking beyond a fund’s name and headline sustainability objective to consider how the underlying portfolio companies reflect the stated sustainability approach.

“Where it is unclear how a holding aligns with the client’s preferences, further engagement with the fund manager will be key to understanding rationale and whether a client’s preferences are being reflected,” she adds.

And Progeny financial planner Richard Gillham says that when matching funds to sustainability preferences, advisers should not overly rely on ESG fund ratings.

“[They] often produce inconsistent results,” he says. “Instead, determine whether other evidence is available in the prospectus or seek other fund documentation regarding its sustainability characteristics.

“For example, if a client has a preference for positive environmental or social impact, then the adviser can identify those funds that demonstrate how positive impact in these areas is actually measured and what real-world change their capital is likely to create, such as a reduction of carbon emissions or more access to affordable medicine.”

Chloe Cheung is a senior features writer at FTAdviser