Sustainability preferences and portfolio construction: five key questions

Written by Sarah Quirke and Brian Flavin

05 October 2023

At Goodbody, we recognise that our clients have diverse needs, including when it comes to investing sustainably. And so, we have developed a thoughtful approach to how we could implement sustainable preferences into our process of portfolio construction.

At our Investment Outlook on 28 September, we sat down with Sarah Quirke, Head of Investment Solutions, and Brian Flavin, Senior Research Analyst, to discuss our approach to sustainability. Here’s what they had to say.

Let’s start with a brief definition of what sustainability means in the context of investment.

Brian: Well, sustainability is about fulfilling the needs of current generations without compromising the needs of future generations while also ensuring a balance between economic growth, environmental care, and social well-being. Now, when it comes to investing or allocating your capital that translates to considering ESG factors as a risk-mitigation tool. That's typically called ESG investing – environmental, social and governance factors.

A good example of integrating ESG into an investment process is to think about a business that emits higher greenhouse gas emissions than its competitors. You might expect that business to meet higher carbon costs into the future, which would affect its relative profitability. And that means that all else being equal, its long-term cost of capital should probably be a little bit higher. So, if you wanted to invest in that business today, the price you pay for that should reflect those risks.

And there’s a whole range of possibilities in terms of how far you can go with sustainable and responsible investing…

Brian: Yes – and that comes from the fact that different investors will think about sustainability in different ways.

I think a useful way to think about it is as a spectrum of possibilities. On the left-hand side of the spectrum, you have financial returns only: the emphasis is on delivering financial returns, and there is little or no consideration for environmental, social or governance practices.

Meanwhile, on the right-hand side of the spectrum, you have impact-only investing, where the emphasis is on delivering societal or environmental benefits often to the detriment of financial returns. An example of which could be social housing.

Responsible investing and sustainable investing sit in the middle of the spectrum – and Goodbody sits in the responsible investing bracket. That means we consider ESG factors as a risk-mitigation tool without compromising long-term financial returns.

To find out more about the spectrum of possibilities or capital, see page five of Wealth Matters, Q3 2023: The Sustainability Issue.

As investment managers, we have a role of responsibility in terms of how we behave and integrate these factors, but investor preferences play a really important role here too….

Brian: Yes, I think most investment managers realise at this point that it's part of their fiduciary duty to incorporate some element of sustainability into their processes. But, more recently, investment firms are required to ask their clients about sustainability preferences as part of the suitability assessment exercise that we already conduct when making investment decisions. I think what's important now is that the industry helps our clients understand the concept of those sustainability preferences because it's not a simple task to get your head around.

The EU has divided them into three different categories: an environmentally sustainable investment; a sustainable investment which may meet an environmental or social objective and follows good governance practices; and an investment that considers the negative impact it may have on a certain ESG factor. Those ESG factors have been defined, and they range from environmental, social, and employee matters. And so, a client can choose one or a combination of any of them, or they may choose none at all.

Sustainability preferences have to be included in the process of portfolio construction. Talk us through our approach and how that works?

Sarah: Sustainability preferences are an increasingly important aspect of a client’s investment objectives, but the client risk profile and the expected return shouldn't be impacted when we include those preferences.

There's a growing range of investments and products that we can use to express those client preferences. A client can have a core sustainable portfolio – assets that have some sustainability bias relative to the typical market benchmark – and then if the client has a specific preference, we may be able to add selected assets to make it more meaningful within the portfolio.

So, for example, if a client comes to us and they have a preference for biodiversity or a focus specifically on mitigating climate change, we could anchor the portfolio with assets that have a relative sustainability bias overall and  on top of that we might layer one or more assets that have a bias towards their specific preference – again, that makes it a little bit more meaningful and expresses it in a stronger way.

So how should investors think about their sustainability preferences practically?

Brian: I think a useful way to start is to think about that spectrum of possibilities that I mentioned earlier. On the far left, you've got the emphasis on financial returns (there's little or no regard for ESG practices) and as you move over towards the right of the spectrum, you start to consider ESG factors. Initially, you see it as a risk-mitigation tool but as you move further to the right of the spectrum, you are increasingly interested in aligning your capital with ESG related opportunities to capture returns and/or to have a positive impact.

So, it’s important to sit down, have a look at that spectrum, and think where you might sit on it.

Sarah: I think from a practical perspective, it's quite a broad area, and it can mean different things to different investors. And with that comes a level of potential complexity.

For any investor thinking about their preferences, it's important to do a little bit of research into that area and to think about what it really means for you. It’s also important to think about how that's going to be implemented because sometimes we might not be able to implement it completely.

So, it’s key to talk to your relationship manager, discuss the complexities, discuss the issues and your preferences, and therefore, when we actually go to implement a portfolio, we can do it in that meaningful way, and it's something that's really fit for purpose.

Want to find out more?

We recently published a special sustainability-focused edition of our quarterly publication Wealth Matters, which covers everything from investing in sustainability at Goodbody to the rise of green bonds. Read it here.

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