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Set out ways to build ESG considerations into planning and constructing a portfolio

CFA® Level I · Portfolio Construction · Basics of Portfolio Planning and Construction · PM.10.b

The idea

Environmental, social and governance considerations can enter portfolio planning at several points. The investment policy statement should record a client's ESG preferences, typically among the constraints or unique circumstances, so that managers are bound by them. Construction approaches differ in how they use ESG information. Negative or exclusionary screening removes sectors or companies, such as tobacco or weapons producers. Positive or best-in-class screening selects the highest-rated issuers within each sector, keeping sector weights near the benchmark. ESG integration adds material ESG factors to ordinary financial analysis. Thematic investing targets themes such as clean energy, and impact investing seeks measurable social or environmental benefit alongside a financial return. Active ownership, through engagement and proxy voting, tries to change company behaviour rather than avoid it. Screens shrink the investable universe, so they can raise tracking error against a conventional benchmark and alter the portfolio's risk profile.

A practice question

From the question bank, with the reason each wrong option is wrong.

A manager excludes all tobacco and weapons producers from a portfolio. This approach is:

  1. best-in-class selectionWhy not: That picks the strongest ESG performers within each sector rather than removing sectors.
  2. negative screening - correct
  3. active ownershipWhy not: Engagement and voting try to change companies, not remove them from the portfolio.

Negative, or exclusionary, screening removes whole sectors or companies from the investable universe on ESG grounds.

A harder one

Which approach seeks a measurable social or environmental benefit alongside a financial return?

  1. ESG integrationWhy not: Integration uses ESG factors to improve risk and return analysis; it does not target outcomes.
  2. Impact investing - correct
  3. Exclusionary screeningWhy not: Screening avoids certain activities; it does not seek a measurable benefit.

Impact investing is defined by intent and measurement: the investor seeks and reports a specific positive outcome as well as a return.

The hardest tier

Where in the investment policy statement should a client's wish to avoid fossil fuel producers be recorded?

  1. Among the constraints - correct
  2. In the return objectiveWhy not: The wish restricts what can be held; it does not state a required return.
  3. Under risk toleranceWhy not: Risk tolerance measures ability and willingness to bear losses. A restriction on what may be held is a constraint.

ESG preferences restrict the investable universe, so they are recorded with the constraints, often as legal or unique circumstances, where they bind the manager.

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