A critical challenge for investment teams mandated with this integration effort is successfully balancing the risk, return and responsible investment objectives. The challenge of integrating responsible investment considerations is more efficiently captured within a single portfolio that balances these risk, return and responsible investment objectives rather than as three individual portfolios targeting outcomes from each objective individually.
The last decade has seen significant progression in the conversation around Responsible Investment (RI). Within the Superannuation sector, the driving force in this advancement has been the evolution in thinking around principles of Universal Ownership and Stewardship. This evolution amongst superannuation funds and asset managers has seen a transition from an awareness and appreciation of ESG to an endorsement of and commitment to the principles of Responsible Investment.
The result of a greater commitment to Responsible Investment has been an increase in the support of broad principles and frameworks (such as UNPRI) by the boards and Investment Committees of these organisations. Having endorsed these broad frameworks, the baton has then been passed on to the investment teams to integrate these RI objectives into their investment portfolio. This has led to a further shift in the discussion around Responsible Investment towards understanding the implications of this integration on the investment outcomes of the resulting portfolio.
Redpoint was founded in 2011 with the integration of Economic, Environmental, Social and Governance (EESG) issues into our investment portfolios as a strong founding principle. Like many other financial organisations, we continue to broaden our Responsible Investment efforts and today, we manage several global and Australian equity portfolios on behalf of clients who collaborate with us to integrate ESG and/or SRI principles into their investment portfolios.
In this paper, we look at some of the considerations investors need to incorporate as they push forward with their own RI integration efforts. A critical challenge for investment teams mandated with this integration effort is successfully balancing the risk, return and responsible investment objectives. This challenge only increases in difficulty as recent regulatory changes add an additional Your Future, Your Super (YFYS) dimension to this challenge requiring investment teams to carefully consider active risk relative to pre-specified benchmarks.
A key finding of this paper is that the challenge of integrating responsible investment considerations is more efficiently captured within a single portfolio that balances these risk, return and responsible investment objectives rather than as three individual portfolios targeting outcomes from each objective individually. Redpoint’s perspective is that, when building responsible investment portfolios, investors need to incorporate all three elements in order to generate better risk-adjusted returns over the longer term.
As Boards and Investment Committees increasingly endorse the Principles of Responsible Investment (PRI), the task of implementation now falls to the investment teams to action these requirements. These additional requirements are complex, multi-faceted and require an extension to the traditional frameworks for multi-manager blending. The below diagram is a conceptual illustration of how this framework might be extended to incorporate additional RI requirements.
The left-hand side of Figure1 shows a conceptual diagram for blending managers with different tracking errors and different investment styles in order to create an optimal blend aimed at maximising risk, return and implementation cost. The right-hand side of Figure 1 shows the extension of this manager blending framework to incorporate an additional Responsible Investment dimension.
It is important to note that Figure 1 is a simplified illustration and that from a theoretical perspective, the responsibility dimension is not entirely independent of the risk and return dimensions. Later in this document, we look at the implications on risk and return from various responsibility considerations in more detail. However, the illustration is helpful when thinking about the overall portfolio objective which is to maximise risk-adjusted returns whilst also addressing RI requirements (i.e., a move from Portfolio T1 to Portfolio R2 in Figure 1).
To date, the most common approach to implementing the shift from Portfolio T to Portfolio R has been by simply restricting the universe of managers from which the optimal blend is constructed. This comes with its own benefits and drawbacks. The benefit is that once the manager universe has been restricted, the traditional manager selection framework can be applied in a similar manner on this now constrained universe of opportunities. The drawbacks of this approach are less flexibility and control: allocators lose flexibility in that they may have a more limited choice of managers to incorporate their specific Responsible Investment policies, and less control in that the limited choice also impacts their ability to manage the risk-return characteristics of the resultant portfolio.
In our experience managing Responsible Investment portfolios, a key observation has been that Responsible Investment policies amongst our clients can be quite varied depending on how the organisation interpret their PRI responsibilities. Hence, Redpoint developed a Responsible Investment framework3 to assist with the customisation and implementation of our client’s policies. Our responsible investment framework incorporates the following key aspects:
For the four considerations listed above, a client’s specific RI perspective means that portfolios may not necessarily incorporate all four of these elements. In some instances, clients may look to address SRI and Alpha within a single portfolio. In other cases, clients may look to address a single component like ESG or Carbon in isolation. The specific nature of client requirements subsequently requires a flexible framework for the integration of responsible investment objectives.
A broader framework for incorporating responsible investment objectives is discussed in detail within our Responsible Investment Policy. In this section, we extend upon this more generalised framework in order to focus in more detail on the investment implications of integrating RI objectives into equity portfolios. This more detailed framework is presented in the following figure:
Error! Reference source not found. presents potential implementation points on the risk return spectrum for a portfolio that has integrated one or more RI objectives. In the subsequent sections of this paper, we describe the reallocation of risk budget within portfolios A to F in order to successfully integrate these objectives.
Note that the numeric values presented in Figure 2 are provided as an indication of typical Australian equity portfolios in the RI space. A similar diagram for a global equity implementation is provided in a more detailed version of this paper. Also, it should be noted that the actual risk and return associated with each portfolio will vary based on the degrees of freedom associated with the investment universe (i.e., global equities have greater scope to diversify systematic risk when compared to Australian equities) and will also be dependent on the specific responsible investment objectives of each client.
An additional point to note is that recent government legislation around YFYS means that risk management of investment portfolios is becoming an increasingly important consideration.
Portfolio A on the risk-return chart presented in Figure 2. has some appeal. By matching the benchmark prescribed in the YFYS legislation, asset owners can focus on asset allocation outcomes rather than the nuances of investment style and/or stock selection within each asset class. Portfolio A also provides an effective lever to manage the overall risk and cost objectives of the aggregate multi-manager portfolio.
Hence, under a scenario where no further return requirements or constraints exist, then an investor can simply hold Portfolio A within each asset class with no further consideration or action required.
However, if the board or investment committee of their organisation has established a detailed RI policy and/or endorsed a specific set of RI principles that need to be integrated into the organisations investment portfolios, then a cap-weighted portfolio of all assets in the investment universe may not meet the overall RI objective of that organisation.
Given that a cap-weighted portfolio of all assets may not meet all of an organisation’s investment needs, an organisation will generally make the decision to move away from Portfolio A. The reasons to move away from the index portfolio generally falls into four broad categories:
Socially Responsible (SRI) – investors hold a specific set of ethical principles that they are unwilling to compromise and would like to exclude specific categories of securities from their investment portfolios.
Emissions – investors hold the view that they are collectively universal owners of all assets and hence have a responsibility to govern their collective investment for the benefit of current and future generations. Under this approach, issues such as global warming need to be addressed from a risk and a long-term capital preservation perspective.
Sustainability (ESG) – again, investors would typically hold the view that as collective owners of all assets, they need to govern these assets for the overall benefit of society by allocating (deallocating) capital to (from) firms that are managing their businesses for the benefit of all stakeholders including the community, the employees, the environment, and shareholders. Investors may also hold the view that companies managed for the benefit of all stakeholders have a lower level of risk and/or have a greater probability of being rewarded through better financial growth over the long-term.
Alpha – clients believe markets are not completely efficient and opportunities to add value through security selection exist.
Once the decision to move away from Portfolio A for return and/or RI reasons is made, a multitude of implementation paths exist. But by making this decision to move away from the index, a key question underpinning all these paths comes to the fore: how do I make best use of my risk budget?
Once the decision to incorporate Responsible Investment objectives is made, an increase in active risk is an inherent consequence of this decision. Now, although investors’ perspectives may vary on whether they think of RI integration as a positive or a negative screening process, from a practical implementation perspective, the introduction of RI objectives results in the underweighting or exclusion of specific securities.
This underweighting or exclusion of securities creates risk, but also provides opportunity. It provides opportunity because it allows the investor to use the active risk budget created by the underweighting/exclusion process to then integrate additional risk and/or return objectives.
So coming back to an implementation perspective, the RI screening process by its nature enforces a certain level of active underweight positioning that needs to be offset by an equal level of active overweight positioning in order to establish the final portfolio. Figure describes how the active money generated by RI integration on the underweight side can be redistributed in order to form Portfolios B to F presented in the risk/return chart in Figure 3
Figure shows how active positioning on the overweight side can be redistributed in a number of different ways to meet an investor’s objectives. In summary:
Portfolio B predominantly redistributes the offsetting overweight positions across the larger companies in the index. Depending on the nature of the larger companies not screened out, this approach can generate systematic biases (e.g. a large overweight to banking stocks) within this final portfolio.
Portfolio C redistributes the offsetting overweight positions to meet a risk reduction objective with the primary goal being to minimise risk from the systematic biases introduced by the screening process.
Portfolio D redistributes the offsetting overweight positions with a single focus of improving the return outcome for this portfolio by selecting securities to upweight using a quantitative alpha model.
Portfolio E redistributes the offsetting overweight positions to meet a dual risk reduction and return enhancement objective, thereby combining the benefits from Portfolios C and D.
Portfolio F redistributes the offsetting overweight positions to meet three objectives integrated into a single portfolio: risk reduction, return enhancement, and carbon intensity reduction.
In a more detailed version of this paper, we look at Portfolios A to F in more detail in order to quantify the risk and return implications of integrating RI objectives into these portfolios. A key observation from this more detailed paper is that by employing risk-controlled portfolio construction techniques along with a quantitative alpha model, investors can:
This is done by redistributing the active money made available from the screening process to significantly improve risk and/or return outcomes in the overall portfolio.
Within the Australian Superannuation sector, Boards and Investment Committees have increasingly endorsed the Principles of Responsible Investment over the last decade. The goal of this endorsement is to support a stable and sustainable financial system with sustainability addressed from a social and environmental perspective in addition to meeting the financial requirements of the underlying investors.
Once endorsed, the task of implementing these PRI requirements has fallen onto the shoulders of the investment teams within these organisations. However, this implementation of PRI requirements into investment portfolios is a multi-faceted problem.
Redpoint has a long history of integrating RI objectives into equity portfolios. Our experience managing RI portfolios has been built on research analysing the risk and return implications of integrating different types of RI objectives (including ESG, SRI, and/or Carbon Intensity reduction) applied over different investment universes (including Australian and global equity portfolios). The overarching observation from our experience is that investors can generate better risk-adjusted return outcomes by:
Given the changes in the Australian market around the new Your Future, Your Super legislation, the need to minimise active risk is becoming a focal point of many discussions. Investing in the cap-weighted index portfolio alleviates the need for any further consideration when it comes to this specific piece of legislation. However, for most investors who interpret their fiduciary obligations more broadly than this legislation may suggest, and who are looking to integrate RI objectives across their aggregate portfolios, the efficient management of risk and return becomes a critical issue.
This paper discusses Redpoint’s integration framework which allows us to tailor our portfolios to integrate the specific RI objectives of an organisation. In a more detailed version of this paper, we extend this framework to quantify the risk and return implications of integrating these RI objectives. Redpoint’s experience managing Australian and global equity portfolios which embed ESG and/or SRI requirements ensures that we continually develop our investment approach and processes to meet the evolving needs of our clients.
For more information
CIO, Senior Portfolio Manager
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Head Institutional Business at GSFM
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1 Portfolio T denotes a blend of investment managers that is agnostic of RI considerations
2 Portfolio R denotes a blend of investment managers which directly embeds RI considerations
3 Redpoint Responsible Investment Policy (Suntharam, Wicas, Smith, Cappetta, & Corr, 2020) - https://www.redpointim.com/redpoint-ri-policy.html
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