Risk and ESG-aligned portfolios

This short paper focuses on how asset and wealth managers can deliver risk and ESG-aligned portfolios to their clients and on how an end-to-end risk portfolio management service, can deliver additional value in terms of stronger returns, higher quality of investments and above all, more client engagement.

When talking about global risks, over the past years the main focus has been on Economic Risks. If we look at the historical global risks identified by the World Economic Forum, we see a lot of blue boxes (linked to economic risk) in the 2007 to 2013 timeframe.

When we look at the last 5 years we see that green and social risks are taking the lead. If we look at 2020, nine out of ten are linked with environmental aspects. If the WEF see these as the most impacting factors shaping future of the world, then it is safe to assume that it will shape and impact heavily investments strategies too. This is the rationale behind placing ESG at the centre of today’s risk management approach for tomorrow.

What does this mean for asset managers and wealth managers?

A recent PwC report highlights that within the next 5 years, ESG assets will reach 50% of total assets, while worldwide, ESG has already reached USD$ 40.5 trillion in assets. Moreover, and this number is even more impressive, a massive 77% of respondents told PwC they intend to stop investing in ‘traditional non-ESG compliant products’ within the next two years.

This is not the only reason to be ESG-ready. It is also a great opportunity to better serve clients as ESG investments help asset managers and wealth managers make better long-term investment decisions for their clients.

By fully integrating ESG considerations into the research and decision-making processes, asset managers and wealth managers will be able to better understand the risks and opportunities of an investment, link their decisions to the trends, risk and opportunities that will reshape the world of tomorrow.

Historically, it has been difficult to show a direct link between good practices and financial performance. Let’s face it, the Friedman doctrine prevalent for most of the last century was not that easy to push aside. Recently, Bank of America showed that European ESG indices were outperforming non-ESG indices between 1 January and 1 September of this year. Meanwhile, the 50 most popular stocks in ESG funds outperformed the 50 most unpopular by around 20% over the same period.

In one of their latest reports on Risk Management, Celent, a division of Oliver Wyman, highlight that, in order to react and generate additional alpha, one needs to be able to support a total portfolio approach where ex-ante analysis (on risk and ESG) are tested and validated by ex-post monitoring, to enable a portfolio manager to react quickly, when there is a change in market conditions.

Surprisingly, this is not as easy as one would expect. Celent highlights how most portfolio and risk managers face challenges of disparate portfolio and risk management information systems, that create operational limitations which directly impact the performances they could generate. A total portfolio approach requires both a maniacal focus on the quality of risk analytics and, more importantly, the ability to have an integrated portfolio and risk management information system supporting a risk-aware investment process. This will enable the investment manager to validate and verify their investment choices against potential impacts (ex-ante) and verify effects (ex-post) at any stage of the process.

Such a process needs to be robust and fully integrated, supported by a proven approach to risk and at the same time able to provide a clear and transparent reporting to clients on investment strategies and portfolio management decisions.

The market crise generated by the COVID-19 pandemic, is a recent example of how important it is to be able to react promptly to changing market conditions. Organisations proactively managing risk, are more risk aware and better at tailoring risk to get a better return on their portfolios. This risk aware approach requires to adopt an end-to-end process, and not specific to a single phase of the process.

An end-to-end process comprises:

(a) the definition of portfolio objectives, client risk profiling, asset allocation and securities selection during the portfolio design phase; (b) the ex-ante risk and ESG analytics for portfolio modelling, construction and optimisation including ‘what-if’ risk scenarios and stress testing in the portfolio implementation phase; (c) before moving to trading execution; (d) post-trade, the portfolio control phase, guarantees continuous monitoring to verify that the risk and allocations remain in line with mandates and corrective actions can be taken quickly and easily to generate value for the end-client.

From an information technology (IT) perspective, an end-to-end risk-aware platform must:

(a) integrate risk data feeds that drive the risk factors analysis; (b) embed a data quality service to elaborate these factors; (c) make a revision/ validation of this data to ensure that the resulting analytics are robust and reliable.

In addition, IT needs to:

(a) guarantee the quality of the data on a 24 X 7 ensuring the data is correctly imported, validated and harmonised to support the process; (b) deliver a high level quality and control of risk and ESG data; (c) manages exceptions and takes corrective actions (for instance, if a new product is placed on the market or requires a specific pricing library, a proper proxy or a request is made for data integration or pricing update); (d) ensure that investment proposals are personalised, tested against compliance rules and clients’ constraints; (e) perform a risk contribution and correlation analysis, to have under control the contribution of each portfolio linked to the overall risk.

Conclusion

Continuous monitoring of market risk and other portfolio factors like ESG analysis, together with proactively alerting on outliers and an exceptions workflow following the 4-eyes principle guarantee proactive management of risk, pre-trade and post-trade.The approach highlighted in this paper needs to take into consideration (a) systematic market risk (the risk inherent in the entire market which cannot be reduced through diversification) as well as (b) specific risk linked to the characteristics of the security (the integration to market and credit risk rating linked to the investment horizon of the security and the underlying portfolio and its objectives) that are not being addressed through portfolio diversification.

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