ESG model portfolios are growing in popularity as asset and wealth managers respond to demand from clients who want their investments to have an impact beyond just returns.

However, gatekeepers offering such portfolios must wrestle with two major questions when designing and constructing these models.

First, are there enough funds and ETFs out there for research teams to build a diversified portfolio of ESG offerings? And do these strategies meet the same standards that would be expected of a non-ESG fund?

Second, how can a model portfolio – which, by its nature, is a one-size-fits-all approach – be used for individual investors to make a given impact, when this could be very different to another investor’s? Or to put it another way, how do gatekeepers and the managers they use define ESG?

Citywire spoke to two leading analysts to find out how they handled both questions.

Where’s the track record? 

When searching for managers in a traditional model portfolio, gatekeepers vet for certain qualities, such as long track records, streamlined definitions of their universes, and diversification that are more limited in ESG models. In a traditional 60% equities/40% fixed income portfolio, for instance, there may be more managers to choose from to populate the sleeves of the model. In an ESG model, however, managers may be newer, smaller, and more niche, limiting the options available for gatekeepers.

While ESG funds are all the rage today, that has not always been the case, meaning there are not many out there with a decent track record, something most analysts require in an early screen.

According to Jason Hoody, LPL’s head of investment manager research, Morningstar’s universe of ESG managers is made up of about 300 managers, 100 of which were added within the last three years.

‘There’s some challenges to that, which is why having strong due diligence in this space is important,’ he said.

Hoody said he maintains the need for a three-year track record when finding funds for the firm’s ESG models even though it means limiting the number of managers he can choose from.

‘I don’t believe we have any with less than a three-year track record, because that does hurt in terms of any sort of performance when you go ahead and put a model out,’ he said.

‘I think on the traditional side, [for example in] large-cap value, you’ve got 400 to choose from, and if a manager shows up with a three-year or less than three-year track record, you’ll consider it, but usually you’re leaning more towards those pioneers.’

LPL Financial launched its first home office ESG model portfolios in 2008. The team made a lot of changes to them in 2017 to reflect the changing landscape.

‘Rather than just focusing on the exclusionary or just best-in-class, we wanted to make sure it reflected what the market was… in terms of making sure we had community investing, ESG integration, and shareholder engagement exposure in the portfolio as well,’ he said.

Laura Tsiguloff, a due diligence analyst at Raymond James, said the team prefers a longer track record, but shorter records can be considered under certain circumstances.

‘Ideally, we would like a five-year track record,’ she said. ‘Others might have a three-year track record, but if they have the assets and performance, and we’re comfortable with the firm and the management team, that is something that we take collectively into consideration when choosing managers for the ESG space.’

Raymond James currently has about $545m in its ESG models, which come in four risk profiles.

Large-cap overload 

Another challenge is the predominance of large-cap managers in the ESG space, making small cap or fixed income ESG managers much less common. This was something both Tsiguloff and Hoody discussed.

‘One challenge, you could say, when constructing or looking at managers within the ESG space is a lot of them have a large-cap tilt due to large caps having the resources and data to be able to provide company disclosures, etc, versus smaller caps with fewer resources,’ Tsiguloff said.

Hoody said while fixed income is not the dominant player in the ESG space, there are opportunities in the asset class that can be tapped. 

‘Fixed income is that real pure play in terms of taking a securitized data set that’s going to give you a triple-A, high-quality, high-credit rating, and the underlying proceeds are going to impact all areas, whether it’s affordable housing or other various underserved communities, as opposed to the opportunity cost of maybe a derivative instrument, where there is no impact,’ he said.

What does it mean?

Finally, the biggest hurdle to ESG as a concept also poses a conundrum for gatekeepers: how to define ESG and, therefore, its models.

‘One of the challenges around the ESG space is that everyone defines it a little bit differently,’ Tsiguloff said. ‘The correlation dispersion between the third-party data rating providers is proof of that.’

Hoody said the confusion was one of the main reasons his group chose to call its portfolios ‘sustainable,’ rather than ‘ESG,’ citing Global Sustainable Investing Alliance (GSIA) criteria.

‘We wanted to make sure we didn’t use a term that could then perpetuate confusion. We went with sustainable investing, because we know that large industry organizations such as GSIA [offer an] umbrella term for this space,’ he said.

Broadly, gatekeepers look for many of the same criteria in ESG managers as they look for in managers in non-ESG funds. However, Hoody said, there are differences to watch out for.

‘You need to understand the universe first, and I think that’s a big one, because different people arrive with different universes because the data can be combed in various ways,’ he said.

‘Some data providers out there aggregate the underlying company ESG data scores, and they come up with rankings for these funds. You can get a large universe of above-average ranked funds that way. We subscribe to the Morningstar approach, where they’re doing prospectus scans and identifying those that are intentionally pursuing a sustainable strategy.’