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How ESG Factors Affect Style Drifting in Portfolio Management

Measuring ESG fund performance is still causing headaches—wealth management firms could face rebalancing hurdles.

When a fund or portfolio diverges from its investment style, asset weight allocation or objective, this is known as “style drift.” Rebalancing is the process where the style drift is minimized or completely eliminated. As most investors are averse to risk, funds and portfolios are rebalanced when stocks exceed their maximum tolerance band—selling stocks to buy safe bonds to reduce portfolio risk. Conversely buying safer bonds when stocks are below the minimum tolerance level.

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

How can an ESG fund diverge so far from its tolerance band when ESG investments are peaking at record levels? There are two potential reasons: 1) a lack of standards and regulation in the measurement and reporting of ESG products and funds is leaving investors scratching their heads over the true measure of their funds and products, and 2) ESG funds aren’t performing as well as they are hyped up to be. This is no surprise given research from Pacific Research Institute that already flagged this in 2019, saying that ESG funds have not yet shown the ability to match the returns from simply investing in a broad-based index fund.

Lack of Regulatory Guidance Causing Massive Inconsistencies

Right now, there is no one standard definition of what an ESG product is or how to report it. Fundamentally asset managers are missing a single regulator or body saying what the metrics need to be measured by. Dozens of standard setters have emerged in recent years, but ultimately they lack any 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 both an entity and instrument level for all asset classes globally. However, different providers can generate and report different ESG scores for the same company.

In terms of how ESG funds are marketed, Fiona Nicolson from the FT Advisor, notes seeing a company offer a “carbon-free” fund, which includes Amazon in its top 10 holdings. Anyone can see that things aren’t always as they appear and that it can be really challenging to understand what measures are meaningful. Some funds, for example, are marked as sustainable because they exclude industries such as weapons and tobacco, where others are more actively pursuing specific ESG goals that make environmental impacts and contributions.

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

New Developments on the Way and Alphabet Soup

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

Until then, investment managers are reliant on using information and data from third-party suppliers that may be incomplete, inaccurate or unavailable when evaluating a security based on ESG standards. Ultimately, investment selection of the sub-fund is based on a subjective judgment from the investment manager. The investment manager may incorrectly assess the ESG characteristics of a security and may wrongly exclude an eligible security, meaning the fund could easily diverge from its tolerance band.

Alternative Demerited Assets Continue to Rise as Investors Look for the Best Returns as ESG Scores May Be Low

If ESG returns have been performing so well for such a long time, then why are many investors only keen to allocate a proportion of their funds to ESG investing, almost like a “try before you buy” approach?

Well, ESG investing is still relatively new in the financial industry, and their performance is still met with skepticism and investors still want to maximize their returns. If an investment manager wants a high-performance stock in their fund or portfolio but the ESG score is poor, they can’t allocate much into it without the need to later rebalance the fund. So we are currently seeing a big push in asset types that don’t have an ESG score at all in order to keep a portfolio’s or fund’s performance high.

Some investors have a lot of capital in the alternative asset space—particularly with high net worth wanting to invest in green projects not just green assets.

Technology Needs to Play Together to Solve Style Drift and Rebalancing

A recent Financial Times article discussing the frequency of rebalancing FTSE Russel explains that some style drift will be inevitable and beneficial if it comes from stocks performing strongly and that some companies may even stop being considered “small” as they enjoy significant gains in the months leading up to the rebalance.

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

It’s essential that these platforms and tools play well with services and integrations. With the plethora of tools, frameworks, and data available to investment managers, they need to use modern, cloud-based platforms that automate and centralize operational processes and reporting into one easy-to-use system via multiple APIs.

Additionally, with the onset of new standards from the International Financial Reporting Standards Foundation, managers need to have the capabilities to report these to the Board very stringently, which is made much easier and efficient by the use of a wealth management system in place that can handle it automatically.

Hannes Helenius, a partner/member of the board at FA Solutions, is a business and product development executive with over 20 years of international experience in driving new initiatives and making an impact in the financial industry.

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