How ESG factors affect style drift in portfolio management

When a fund or a portfolio deviates from its investment style, its asset allocation or its objective, it is called “style drift”. Rebalancing is the process where style drift is minimized or completely eliminated. Since most investors are risk averse, funds and portfolios are rebalanced when stocks exceed their maximum tolerance band, selling stocks to buy safe bonds in order to reduce portfolio risk. Conversely, buy safer bonds when stocks are below the minimum tolerance level.

For example, the ESG allocation in funds and portfolios, which has seen a massive increase, could trigger rebalancing if it deviates from its target ESG score due to changes in the overall allocation.

How can an ESG fund deviate so far from its tolerance band when ESG investments are peaking at record highs? There are two potential reasons: 1) a lack of standards and regulation in the measurement and communication of ESG products and funds leaves investors wondering the true measurement of their funds and products, and 2) ESG funds are not. not as efficient as as they are in a hurry to be. This is not surprising given research from the Pacific Research Institute that reported it already in 2019, claiming that ESG funds have yet to show the ability to match the returns of just investing in an index fund. broad based.

Lack of regulatory guidelines causing massive inconsistencies

Currently, there is no standard definition of what an ESG product is or how to report it. Basically, asset managers lack a single regulator or body indicating by what metrics should be measured. Dozens of standard setters have emerged in recent years, but ultimately they lack consistency.

For example, Fitch Group, one of the Big Three credit rating agencies, announced the launch of Sustainable Fitch, a product through which the company will offer ESG ratings at the entity and instrument level for all asset classes around the world. However, different vendors can generate and report different ESG scores for the same company.

Regarding how ESG funds are marketed, Fiona Nicolson of FT Advisor notes that one company offers a “carbon-free” fund, which includes Amazon in its top 10 holdings. Everyone can see that things are not always as they appear and it can be very difficult to understand which metrics are meaningful. Some funds, for example, are marked as sustainable because they exclude industries such as arms and tobacco, while others more actively pursue specific ESG goals that have environmental impacts and contributions.

In March of this year, the EU adopted a new disclosure regulation that sets out strict and detailed rules for fund managers, financial advisers and many other regulated firms in the EU as well as those who market their funds. in the EU to take greater responsibility for sustainability. risks in their operations.

New developments on the way and alphabet soup

A significant evolution of the standards (but not of the new acronyms) could be the launch of the International Sustainability Standards Board of the International Financial Reporting Standards Foundation, which will aim to define standardized measures for the reporting of ESG measures.

Until then, investment managers depend on the use of information and data from third-party providers which may be incomplete, inaccurate or unavailable when valuing a security against ESG standards. Ultimately, the investment selection of the sub-fund is based on the subjective judgment of the investment manager. The investment manager may incorrectly assess the ESG characteristics of a security and may incorrectly exclude an eligible security, which means that the fund could easily deviate from its tolerance band.

Alternative demerit assets continue to rise as investors seek the best returns as ESG scores may be low

If ESG returns have been performing so well for so long, then why are many investors only willing to allocate a portion of their funds to ESG investing, almost like a ‘try before you buy’ approach?

Well, ESG investing is still relatively new to the financial industry, and their performance is still greeted with skepticism and investors still want to maximize their returns. If an investment manager wants a high performing stock in their fund or portfolio but the ESG score is poor, they can’t allocate much to it without needing to rebalance the fund later. We are therefore currently witnessing a strong surge in asset types that have no ESG score at all in order to maintain the performance of a portfolio or a fund at a high level.

Some investors have a lot of capital in the alternative asset space, especially with high net worth who want to invest in green projects and not just green assets.

Technology must play together to resolve style drift and rebalance

A recent Financial Times article on FTSE Russel rebalancing frequency explains that some style drift will be inevitable and beneficial if it comes from high performing stocks and some companies may even cease to be seen as “small.” because they benefit from significant gains in the preceding months. until rebalancing.

For smaller wealth management companies and offices, rebalancing may need to be done more frequently. When using older technology, bottlenecks can be created with these more ad hoc tasks. With a modern platform, rebalancing can be done when needed and alerts are issued to notify when assets start to drift. Adding new variables to track in the rebalancing formula can also be simplified.

It is essential that these platforms and tools work well with services and integrations. With the plethora of tools, frameworks and data available to investment managers, they must use modern cloud-based platforms that automate and centralize business processes and reporting into one easy-to-use system through multiple API.

In addition, with the emergence of new International Financial Reporting Standards Foundation standards, managers must have the ability to report them to the Board in a very strict manner, which is made much easier and more efficient by the use of a wealth management system in place that can manage it automatically.

Hannes Helenius, Partner / Board Member of FA Solutions, is a Business Development and Product Manager with over 20 years of international experience driving new initiatives and impacting the financial industry.

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