Call for more consistency in ESG portfolio integration

Changing market dynamics are highlighting for investors the potential cost of their disproportionate focus on equity risk, according to market experts.
Call for more consistency in ESG portfolio integration

Sustainable investing advocates are urging asset owners to take a more holistic approach to environmental, social, and governance (ESG) integration in their portfolios, in the light of a re-pricing of assets that is taking place against a background of international conflict, inflation and how central banks are responding to these events.

For ESG risk analysis to succeed, “investors need to be asking questions about risk and what they mean for long term-returns on a more consistent basis”, according to Sydney-based asset consultant Alexis Cheang.

“Historically, ESG risk analysis has disproportionately focused on listed equities, but the Ukraine crisis has highlighted the impact on emerging market debt, sovereign debt and high yield,” said Cheang at the Responsible Investment Association of Australia's annual conference.

Inflation has taken off around the world, initially fuelled by the supply-side disruptions of COVID-19 and more recently by higher food, commodity and oil prices as a result of the Russia-Ukraine war.

For pension and superannuation funds, most of whom will have a major chunk of their investments tied up in fixed income investments, rising inflation and interest rates are key considerations.

In fixed income, the heightened geopolitical risk in Europe and Asia has seen capital outflows from emerging market sovereign debt, while high-quality, developed-market sovereign bonds are maintaining stable capital inflows despite rising domestic inflationary pressures.


Australia’s sovereign wealth Future Fund has been warning for some time that it sees heightened risk in global markets and that it doesn’t expect investment returns to be maintained at historic levels. Having posted a negative return in the first quarter of this year, Raphael Arndt, the Future Fund’s CEO confirmed that it has taken some risk off in Q2.

New Zealand Super has developed a roadmap to integrate ESG more fully into its investment framework. “The responsible investment (RI) team is now embedded within the wider investment team and we have initiated RIAA training for all our investment professionals,” said CEO Matt Whineray in an online briefing this month.

“In addition, we have also rated the RI strategies of our external managers and embedded ESG considerations into our risk allocation process.”

Investment managers are trying to improve their credit risk analysis in this area. The pricing model that Federated Hermes developed in 2017 to capture the influence of ESG factors on credit spreads. shows a convincing relationship between ESG risk and credit spreads.

But investors still complain about a lack of reliable and consistent data. More and more clients of the leading credit rating agencies such as Fitch, Standard & Poor’s and Moody’s are demanding extra detail from them on the ESG factors that affect individual credit-rating decisions. But there remains no universal standard for what constitutes an ESG risk.

As reported, asset managers’ over-reliance on ESG data analytics firms, such as MSCI and Sustainalytics, has also become part of the problem. Sustainability expert Sasja Beslik cited MSCI’s decision to downgrade its ESG rating of the Russian government from B to CCC on March 8, as "eight years too late.”

At the RIAA event, investors also faced criticism from ESG pioneer and CEO of the Blended Capital Group, Paul Clements-Hunt for failing to adequately address the risk to their portfolios of the conflict in Ukraine.

He suggested that ESG should be called into question for failing to halt the flow of investment to the Russian regime and agreed with Cheang, that the ability of asset owners to address systemic risks across the ESG spectrum will positively impact their investment portfolios. “It’s not climate in one bucket, biodiversity in another and geopolitics in another.”

Institutional investors and sovereign wealth funds appear to be responding to these new challenges. According to State Street’s Behavioural Risk Scorecard,   an aggregate measure of risk appetite derived from the capital flows and holdings by institutional investors  which came out in late April, "the risk aversion evidenced by institutional investors through their capital flow decisions has also become more broad-based, with evidence of risk-off behaviour manifesting across investors’ equity, fixed income and foreign exchange decisions over recent months.”


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