Do you need the fingers of both hands to count your investments? Truth is, you can get pretty much all the domestic and foreign diversification you need with just three index funds: a total U. Can you explain exactly why you bought each investment you own? Ideally, you should also be able to quantify the benefit you receive from owning it by citing research or pointing to performance figures that demonstrate how it enhances the tradeoff between risk and return.
As different investments earn different returns, you must periodically rebalance your portfolio to restore it to its proper proportions. Do you regularly add new investments to your portfolio? Walter Updegrave is the editor of RealDealRetirement. You can reach him at walter realdealretirement. The selection of material factors is often influenced to some extent by exposure to asset classes, geographies, and specific companies.
For example, governance factors tend to be especially important for private equity investments , since these investments are typically characterized by large ownership shares and limited regulatory oversight. Once an investor has set priorities, it can select these techniques accordingly, using the following questions as a guide:. Is risk management a focus? Negative screening is essential for investors that wish to constrain risk.
It entails excluding companies or entire sectors or geographies from a portfolio based on their performance with respect to ESG factors. Negative screening was the basis for many of the earliest sustainable investing strategies.
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The availability of ESG performance data for example, carbon emissions now allows investors to apply more nuanced and sophisticated screens, filtering out companies that do not meet their standards or are below industry averages for particular ESG factors. Is value creation a focus?
Performance-focused investors can use negative screening to eliminate companies that may be less likely to outperform in the long run. They can also practice positive screening, by integrating the financial implications of ESG performance in fundamental analysis. With this approach, many of the same research and analysis activities that investors perform to choose high-performing assets are extended to cover material ESG factors.
In this way, investors can seek out assets with outstanding ESG performance or sustainability-related business priorities such as high energy efficiency. Does the investor engage with management teams? Some institutional investors try to improve the performance of portfolio companies by taking board seats or engaging in dialogue with management. This approach can also be helpful in sustainable investing strategies: an institutional investor might choose to acquire a stake in a company with subpar ESG performance, then engage with its management about potential improvements.
If an institutional investor ordinarily takes board seats or engages management teams, then it might consider adding sustainability issues to its agenda. Some investors also take part in external collaborations, such as Eumedion in the Netherlands, that collectively engage companies in dialogues on sustainability issues and pool shareholder voting rights to influence management decisions. A few leading investors embed ESG specialists within their investment teams, though some opt for other arrangements. The following three questions can help institutional investors fit their ESG-focused staff and resources into their existing operations:.
What expertise is needed to carry out the sustainable investing strategy? The factors and techniques an investor chooses will determine what expertise is required. Investors that emphasize environmental performance, for instance, will need specialists in relevant environmental topics and management practices. Those that actively engage with management teams may need specialists with executive experience. Companies that rely on screening techniques will likely benefit from expertise in quantitative analysis.
How should an investor obtain ESG expertise? In-house ESG teams range from one or two full-time staff members to 15 or more, depending on portfolio size and approach to sustainable investing.
Some investors may not need full-time ESG staff at all. In addition, many institutional investors take part in external networks such as the United Nations Principles for Responsible Investment PRI and the Portfolio Decarbonization Coalition, which support investors in incorporating ESG factors in their investment decisions. Leading investors also continuously build the ESG capabilities of their portfolio managers. Where should ESG specialists fit into the organization? Some investors put their ESG specialists outside the investment team for example, within a communications group. Leading investors typically embed ESG experts within their investment teams, with a head of ESG who reports to the chief investment officer.
ESG specialists then provide ongoing support to portfolio managers.
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Some funds have made it a priority to hire ESG specialists with strong investment backgrounds. Other funds have chosen not to have dedicated ESG specialists, but to assign responsibility for related issues to ESG-trained portfolio managers. At one Scandinavian investor, portfolio managers must fully account for all drivers of risk and return, including those related to ESG factors.
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Before hiring external managers, they also conduct thorough due diligence. Our interviews suggest that institutions with sophisticated approaches to sustainable investing have made ESG considerations an integral part of their performance-management processes. The following two questions can help investors devise effective means of monitoring performance:. How can we ensure external managers conform to our sustainable investing strategy? Leading funds have integrated ESG elements into their due diligence processes for external managers.
Side letters, which augment the terms of a contract, can be used to specify ESG performance standards for an external manager. Once an external manager has been hired, leading investors evaluate their ESG performance as part of their semiannual or annual performance reviews. Some leading investors have a continuous dialogue with their external managers, through which potential ESG issues can be flagged and discussed. How can we ensure our in-house investment team adheres to the sustainable strategy?
Leading funds also make ESG considerations part of their processes for managing the performance of in-house portfolio managers. Leading institutional investors reinforce their commitment to sustainable investment by disclosing performance and describing their management practices. The most advanced provide detailed descriptions of how they are enacting their sustainable investment strategies, along with quantitative measures of their performance relative to targets.
The following questions can help when it comes to shaping effective approaches to external reporting:. What is the goal of reporting on ESG performance? Investors should define what they hope to accomplish via external reporting and disclosure. Government pensions, for example, may have to fulfill public-policy requirements. This technique is particularly relevant to proactive engagement: investors can exert influence on portfolio companies by describing the performance gaps they have identified and the improvements that companies are making.
What information should be disclosed?
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Investors generally have wide discretion on what to disclose about their sustainable investment approach: strategies, companies excluded, ESG performance measures, and accounts of management dialogues, to name a few. Over the past few years, disclosures have become more detailed in areas like policies, targets and outcomes, focus areas, and specific initiatives. Disclosing different kinds of ESG information serves different purposes. To encourage portfolio companies to strengthen ESG performance, disclosing information about high-priority ESG factors, company dialogues, and exclusion lists may be helpful.
Embedding sustainable investment practices into investment processes is a long-term endeavor, by which most investors gradually adopt more sophisticated techniques. The practices described above, already in wide use, can help investors develop or refine sustainable investing strategies. It is also worth considering the following approaches, which are still evolving among investors at the front of the field:. A few funds have begun to systematically assess how their entire portfolios are exposed to material ESG risks notably, climate change and energy consumption.
Such a broad review requires significant staff time, resources, and capabilities. It also means developing a view on the long-term development of ESG-related factors and related market forces for example, sales of electric vehicles and movements in energy prices and their impact on the financial performance and valuations of holdings. In addition, advanced investors are developing dashboards of key indicators to watch, with trigger points that call for mitigating actions to manage risks effectively.
How leading investors integrate sustainability
Recent efforts to establish industry-wide standards for measuring a carbon footprint have resulted in progress, but an established set of metrics across most other sustainability topics has yet to be developed. Using ESG triggers to find new investment opportunities. If assessing a whole portfolio with regard to ESG risks is one side of a coin, then seeking investment opportunities based on ESG factors is the other side.
As with assessing risk exposure, institutional investors will need a point of view about ESG-related trends and their long-term effects on asset prices. One way to develop a thesis is to identify the most significant trends and the sectors they influence for example, asking what opportunities will be created by the widespread shift toward renewable energy. Early approaches involve prioritizing certain SDGs and planning investment strategies to improve corporate performance in those areas.
AP2 also publishes examples of how its investments contribute to the SDGs. This creates transparency on how the institutional-investor community can be a catalyst for change for a more sustainable society, addressing some of the prioritized challenges of humankind. The sustainable investing market has grown significantly as demand for sustainable investment strategies has surged and as evidence has accumulated about the benefits of investing with ESG factors in mind. Most large funds are seeking to develop their sustainable strategies and practices, regardless of starting point.