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March 2023 / ASSET ALLOCATION STRATEGY

Including ESG Preferences in Asset Allocation

A systematic portfolio construction framework to reflect ESG considerations.

Executive Summary

Considering environmental, social and governance (ESG) factors in portfolio construction has become increasingly important as more investors include these as part of their investment objectives.1 With this in mind, we have developed an intuitive and transparent framework to analyse the ESG characteristics of portfolios and evolve their asset allocation and portfolio construction by explicitly and systematically embedding each investor’s ESG preferences. To do so, we consider not only the return and investment risk (e.g., volatility, downside risk) parameters of each investment, but also the ESG risk score. 

Our framework can help investors with three main activities: 

1. Analyse and calculate a portfolio’s ESG risk scores,2 alongside traditional return and investment risk parameters. This could facilitate informed discussions and, potentially, changes to the asset allocation while considering ESG criteria. 

2. Add new investments to existing portfolios while considering ESG factors. 

3. Design a new asset allocation that reflects the investor’s preferences with respect to asset classes’ ESG scores within a risk‑aware framework. 

An Intuitive, Systematic and Flexible Framework

Considering ESG criteria in portfolio construction becomes necessary when such criteria are part of a portfolio’s investment objectives. We have developed a framework to reflect each investor’s ESG preferences in asset allocation and portfolio construction. We published the framework in our paper Adjusting Asset Allocation for ESG Preferences in September 20223 (available upon request). 

In a nutshell, our framework considers the expected return and investment risk (using measures such as volatility or downside risk) when constructing a portfolio alongside a second risk parameter for each investment: its ESG risk score. It allows investors to analyse and calculate the return, investment risk, and ESG risk of portfolios, as well as to optimise portfolios on these three dimensions. The optimisation considers investment risk based on the risk tolerance and objectives of the investor and ESG risk based on the ESG preference parameter of the investor.

Our framework follows four stages.

1. Gather Data

We collect the relevant investment and ESG data for the investments in the universe. For investment data, we can use any set of capital market assumptions (CMAs) or extract CMAs from an existing portfolio using reverse optimisation (extracting the CMAs that would lead an optimiser to the existing asset allocation). For ESG data, we use ESG risk scores for each investment, provided by the investor, a third party, or by using our proprietary model.

2. Adjust Utility

We adjust the expected utility of investments based on both their investment and ESG data. Utility is a function of the expected return—the benefit gained from the investment—less investment risk (e.g., volatility, downside risk) and less the ESG risk of each investment—the two sets of risk criteria of the investment.

3. Optimise Allocation

Using a utility maximisation process (similar to traditional mean‑variance optimisation), we optimise the portfolio using the ESG‑adjusted expected utility of the investments.

4. Assess Portfolio

By generating a range of optimised portfolios with different sensitivities to investment and ESG criteria, our process can formulate an informed view of the portfolio construction choices. This can guide investors to arrive to a portfolio that best addresses both their investment and ESG objectives and the potential trade‑offs between the two sets of goals.

 

Read the full report here: (PDF)

IMPORTANT INFORMATION

This material is being furnished for general informational and/or marketing purposes only. The material does not constitute or undertake to give advice of any nature, including fiduciary investment advice, nor is it intended to serve as the primary basis for an investment decision. Prospective investors are recommended to seek independent legal, financial and tax advice before making any investment decision. T. Rowe Price group of companies including T. Rowe Price Associates, Inc. and/or its affiliates receive revenue from T. Rowe Price investment products and services. Past performance is not a reliable indicator of future performance. The value of an investment and any income from it can go down as well as up. Investors may get back less than the amount invested.

The material does not constitute a distribution, an offer, an invitation, a personal or general recommendation or solicitation to sell or buy any securities in any jurisdiction or to conduct any particular investment activity. The material has not been reviewed by any regulatory authority in any jurisdiction.

Information and opinions presented have been obtained or derived from sources believed to be reliable and current; however, we cannot guarantee the sources' accuracy or completeness. There is no guarantee that any forecasts made will come to pass. The views contained herein are as of the date noted on the material and are subject to change without notice; these views may differ from those of other T. Rowe Price group companies and/or associates. Under no circumstances should the material, in whole or in part, be copied or redistributed without consent from T. Rowe Price.

The material is not intended for use by persons in jurisdictions which prohibit or restrict the distribution of the material and in certain countries the material is provided upon specific request.  

It is not intended for distribution to retail investors in any jurisdiction.

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