ESG considerations in portfolio planning and construction

What are the six ESG approaches?

Memorize

Responsible investing is the broad umbrella for principles that require environmental, social and governance (ESG) themes to be considered when deciding whether to invest in a company and while owning it. Sustainable investing is a close cousin that focuses on sustainability issues in the process. Investors increasingly write these policies into the IPS itself, and the exam works from that assumption. Terminology varies across the industry, but the curriculum uses six generic approaches. Know them by what the manager does.

ESG investment approachesno consensus on terminology; these six are the generic ones

• Negative screening Memorize exclude companies, sectors or countries
  • Example no thermal coal miners
• Positive screening Memorize include those with better ESG performance, usually relative to peers
  • Example top third of each sector by ESG score (best-in-class)
• ESG integration Memorize systematically include material ESG factors in analysis and valuation
  • Example lower a utility’s cash-flow forecast for carbon costs
• Thematic investing Memorize invest in themes or assets tied to ESG factors
  • Example a water-infrastructure fund
• Engagement (active ownership) Memorize use shareholder power to change company behavior
  • Example voting for board diversity; meeting management on emissions targets
• Impact investing Memorize intend measurable social or environmental impact plus a financial return
  • Example a fund financing affordable housing, with reported outcomes

Approach	What the manager does	Example
Negative screening	excludes companies, sectors or countries	no thermal coal miners
Positive screening (best-in-class)	favors companies with better ESG performance than peers	the top third of each sector by an ESG score
ESG integration	systematically includes material ESG factors in analysis and valuation	lowering a utility’s forecast cash flows for carbon costs
Thematic investing	invests in themes or assets tied to ESG factors	a water-infrastructure fund
Engagement (active ownership)	uses shareholder rights to change company behavior	voting for board diversity, meeting management on emissions targets
Impact investing	targets measurable social or environmental impact plus a financial return	a fund financing affordable housing, with reported outcomes

Sort each description into its approach, then switch on the screen to see how exclusions change a benchmark.

Exam tip Exclude = negative. Best of peers = positive. Inside the model = integration. A theme = thematic. Uses votes = engagement. Measures outcomes = impact.

Where does ESG show up in the process?

Use it

ESG in portfolio planningpolicy first, then benchmark, then security-level work

• IPS Use it client values recorded, often under unique circumstances
• Asset classes and benchmarks Use it exclusions shrink the universe and can change risk and return; use a matching benchmark
• Portfolio construction Use it integration changes cash flows, discount rates or scenario weights; engagement and voting follow

• IPS. Client values and preferences are recorded, often under unique circumstances, sometimes with a dedicated responsible-investing section.
• Asset classes and benchmarks. Screens limit the securities to choose from, which can change the risk and return expected from the class. Asset classes are normally represented by standard benchmarks, so with exclusions an off-the-shelf benchmark may not apply. Providers offer benchmark indices that reflect common exclusions, and managers prefer to be measured against a benchmark that reflects the limited universe.
• Portfolio construction. Integration feeds ESG factors into forecasts, discount rates and scenario weights, and can change position sizes. Managers also need instructions on the exercise of shareholder rights and on the choice of strategies.

Integration is increasingly seen as a process improvement rather than an entirely new way to invest, so more asset owners expect their managers to beat the regular benchmark. ESG data range from structured numbers (carbon footprint, executive pay, staff turnover, lost-time injuries) to qualitative judgment, and disclosure rules are developing.

How are engagement, themes and impact put to work?

Know the idea

• Engagement takes time and often reflects the client’s interest more than the manager’s, so both must agree who votes, who files shareholder proposals and who talks to management. Voting may be delegated to the manager under its stewardship policy , handed to a proxy agent, or kept by the client. Collaborative engagement, where several investors act together, is more likely to get a company’s attention.
• Thematic allocations bias the asset-class portfolio toward a theme, so the manager should show how the theme changes the total risk and return. Specialist managers are usually needed.
• Impact investing selects opportunities on their intention to create a positive, measurable environmental and social outcome.

Does limiting the universe cost return? Supporters argue that better governance and the avoidance of material risks improve returns; opponents point to the cost and the narrower choice. Academic evidence is mixed, but adoption is strong, and integration is now common in mainstream funds, not only in client-specific accounts.

Go deeper Why materiality differs by industry

Governance matters for almost every company. Emissions and resource use matter most for energy, utilities and materials; labor practices and supply chains for apparel and retail; data privacy for technology. ESG integration therefore looks at material factors for each industry, not at the same list for every company. Material means likely to affect cash flows, risk or the cost of capital.

Go deeper Standards and greenwashing

Frameworks such as the Principles for Responsible Investment, the UN Global Compact and the Organisation for Economic Co-operation and Development (OECD) Guidelines for Multinational Enterprises set out standards that asset owners use as the basis of responsible-investing policies. Because labels are not uniform, a fund described as “green” or “sustainable” may mean different things; claims need checking against what the manager actually does, which is why disclosure standards continue to develop.

Go deeper Links to Corporate Issuers

Governance is the G in ESG. The lessons on corporate governance and on investors and stakeholders in the Corporate Issuers topic show the rights, boards and stakeholder interests that engagement and integration build on.