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Building Diversified Ethical Portfolios

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Despite the rapid demand and growth of ESG and sustainable investing in Australia, investors are not yet spoilt for choice when it comes to constructing a well-diversified ESG portfolio across the full risk spectrum of investment products.

Advisers and investors wanting to build an exclusively ESG-centric portfolio may find it difficult to achieve adequate diversification as product options are still relatively limited on the defensive side of the portfolio, and more diversifying asset classes outside of equities are also limited.

Australia’s ESG Market is Growing

According to the 20th Annual RIAA Benchmark Report September 2021, Responsible Investment Assets Under Management (AUM) was at $1.281 Billion in a total Australian Managed Fund market of $3.199 Billion. This equates to approximately 40% of Australian professionally managed assets.

The Australian Responsible Investment Market is growing with more managers introducing some form of ESG integration into their portfolios through the use of positive and negative screening and corporate and engagement shareholder action.

This growth mirrors global trends with the Global Sustainable Investment Review 2020 citing sustainable investments reaching US $35.3 Trillion in assets under management, equating to 36% of all professionally managed assets.

Achieving Adequate Diversification in a Small Pool

From an equities perspective, the ASX 200 is a fairly small pool of investment, particularly when you overlay ESG filters. Even the overlay of a medium green (and not deep green) filter reduces the pool of investment options significantly.

“Some sectors lend themselves to ESG, measurement and verification better than others, so it’s possible that you get a bias towards those sectors in portfolios that are dedicated ESG”.

“From a portfolio construction perspective, looking at a total portfolio approach, you’d want to certainly be mindful that you don’t end up with an overweight allocation. Let’s say you employ three global ESG equity managers, and you find they’re all overweight in alternative energy. Indirectly what you end up with is an Alternate Energy Fund” Philip Moffitt.

Expanding the Investment Pool

This brings into question whether an adviser needs to look globally and specifically outside of Australia when building diversified client portfolios for ethical investors.

Australia’s share market represents less than 2% of Global Market Capitalisation.

Globally the ESG and sustainability are much more defined and certainly more ingrained from a political and societal level, through to the business and investment and consumer level.

Europeans are leaders in the ESG space, which Philip Moffitt attributes to Europe’s recognition of the ageing population, their social welfare state and the cost of environmental and social degradation directly hitting the national balance sheets. In Northern Europe, the government is on the hook for healthcare, education and employment outcomes and so on, so the direct costs of poor ESG are felt by the public purse” he says.

ESG aside The Fundamentals of Investing Still Matter

Environmental, Social and Governance measures aside, what is still imperative is that the fundamentals of well thought out and carefully planned product and investment manager selection still apply in the construction of client’s ethical portfolios.

When searching for the right ESG solution for a client, Elizabeth Hatton, Financial Planner and Director of Viva Financial Planning, advises to “step back, look at how the actual investment philosophy applies, and figure out what’s reasonable with a fair amount of certainty, and to be critical at all times”.

“I’d still be looking for an investment manager who’s talking first and foremost about financial return and diversification benefits within the portfolio. You’re looking for an asset that’s going to give you really strong returns and reduce risk through diversification of the portfolio”.

EGS funds need to deliver the right building blocks to empower investors to meet their financial objectives, remain aligned to their values, and, importantly, channel capital to help solve looming climate and social challenges.

Not to forget also that when investing globally also introduces currency risk and other considerations to portfolio construction.

Ultimately Sustainability is a Balancing Act between Impact + Financial Return

Caution is also given to those products or managers that are pitching ESG or impact first and return second. The ethics of a fund are very important, but so too are returns for investors. They should not have to compromise on either. If a business is not going to generate competitive financial returns, then it may not be a sustainable business or investment. Phillip Moffitt, Co-Founder Beckon Capital, Director at Aware Super and Director at Green Road Consulting offers advice “If the asset doesn’t generate competitive financial returns, the strategies won’t survive”.

James Hardwood, Senior Portfolio Analyst with Russell Investments added “I encourage Advisers to look under the bonnet as much as possible. Look at how the managers select securities and review their philosophies. It’s also important to align client requirements in terms of the shade of green of products.  Look for a well-balanced diversified portfolio”.

He also suggests that “Having certification from RIAA is a really important step in the right direction if ESG is something you’d like to incorporate in your client’s portfolios”.

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This article was written based on discussions held in the XY Adviser Podcast Ethical Investment Series #15 hosted by Fraser Jack in conversation with Elizabeth Hatton, James Harwood, Paul Garner, Alexandra Brown, and Philip Moffitt. The full podcast can be found here.

 

 

References
https://responsibleinvestment.org/resources/benchmark-report/

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