March 2023 / ASSET ALLOCATION STRATEGY
Including ESG Preferences in Asset Allocation
A systematic portfolio construction framework to reflect ESG considerations.
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.
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