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Why it’s important to consider ESG in asset allocation

ESG is not just a company-level issue, says Pendal multi-asset portfolio manager ALAN POLLEY

ENVIRONMENTAL, social and governance factors should be incorporated into portfolios at an asset allocation level — rather than only at individual stock selection level, says Pendal’s Alan Polley.

ESG has long been a critical factor in investing, aiming to identify and avoid risk and financial loss as well as bring about change.

But it’s often considered only at a company level.

A better investing framework would incorporate ESG factors at an asset allocation level before the security selection process even takes place, says Polley, a portfolio manager in Pendal’s multi-asset team.

“We know asset allocation is the primary driver of investment returns. It explains about 90 per cent of the return variability in a portfolio according to the original Brinson study,” says Polley.

“But ESG integration in asset allocation is not something that is covered in the industry.

That’s for two reasons:

“First, because it’s hard. How do you think about it?

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“And second, in my opinion, asset allocation is not well shaped in the industry overall.

So, where does ESG fit into an investment process that isn’t very well defined?”

Three-part framework

Polley offers a three-part framework for thinking about ESG in asset allocation.

The practice of asset allocation fundamentally involves three decisions, he says:

  • Changing allocations between existing asset classes
  • Changing the definition of existing asset classes
  • Introducing new asset classes

“When you think about asset allocation, you really doing one of those three things — there’s no other decisions.

“Given those three decisions sets, incorporating ESG is quite simple.”

Climate change example

Polley uses the environmental factor of carbon emissions as an example.

“Emissions intensity in Australia is vastly higher than global markets. So, if you think climate change is an important investment consideration, you might tilt away from Australian equities towards international developed markets.

“There is a ESG headwind to the Australian market and the Australian economy in its exposure to fossil fuels.”

Pendal’s multi-asset funds have incorporated this insight by reducing a portfolio’s home bias and tilting instead towards US and European shares.

The framework also holds true for social and governance factors.

“Emerging markets are not great on E, S or G — they are emerging for a reason. But we’re not going to rule out the asset class because it’s an important source of diversification and returns.

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“So, we changed the definition — for emerging markets, we’ve removed repressive regimes: China, Saudi Arabia, Russia and a few others. From an ESG standpoint, we just don’t think they’re true to label.”

The change means the portfolios can still hold emerging markets assets and lifts the weightings to less risky markets.

New asset classes

The third asset allocation decision — introducing new asset classes — has allowed the portfolios to lift exposure to the energy transition theme.

“The conversion from fossil fuels to renewables is a secular tailwind so we have created a listed renewables infrastructure asset class. We’re investing directly into renewable listed investment companies — the underlying assets are pure infrastructure like batteries, wind farms, solar and hydro.

“It’s great because we tend to focus on investing in primary market stock issuances, so we’re directly funding the development of these renewables assets.

“It’s a great way of getting a big lick of ESG exposure into our portfolios within the asset allocation construct.”

It’s important that sustainable investors step beyond simple security selection, says Polley.

“Security selection is just the first generation of ESG thinking — the 1G.

“Asset allocation is 2G and you can even step up to a third generation and consider ESG in the whole of portfolio construction.

“But most of the industry is still stuck at 1G.”


About Alan Polley and Pendal’s Multi-Asset capabilities

Alan is a portfolio manager with Pendal’s multi-asset team.

He has extensive investment management and consulting experience. Prior to joining Pendal in 2017, Alan was a senior manager at TCorp with responsibility for developing TCorp’s strategic and dynamic asset allocation processes covering $80 billion in assets.

Alan holds a Masters of Quantitative Finance, Bachelor of Business (Finance) and Bachelor of Science (Applied Physics) from the University of Technology, Sydney and is a CFA Charterholder.

Pendal’s diversified funds provide investors with a variety of traditional and alternative asset classes and strategies.

Find out more about Pendal’s multi asset funds:

Contact a Pendal key account manager here


This information has been prepared by Pendal Fund Services Limited (PFSL) ABN 13 161 249 332, AFSL No 431426 and is current at August 25, 2022. PFSL is the responsible entity and issuer of units in the Pendal Multi-Asset Target Return Fund (Fund) ARSN: 623 987 968. A product disclosure statement (PDS) is available for the Fund and can be obtained by calling 1300 346 821 or visiting www.pendalgroup.com. The Target Market Determination (TMD) for the Fund is available at www.pendalgroup.com/ddo. You should obtain and consider the PDS and the TMD before deciding whether to acquire, continue to hold or dispose of units in the Fund. An investment in the Fund or any of the funds referred to in this web page is subject to investment risk, including possible delays in repayment of withdrawal proceeds and loss of income and principal invested. This information is for general purposes only, should not be considered as a comprehensive statement on any matter and should not be relied upon as such. It has been prepared without taking into account any recipient’s personal objectives, financial situation or needs. Because of this, recipients should, before acting on this information, consider its appropriateness having regard to their individual objectives, financial situation and needs. This information is not to be regarded as a securities recommendation. The information may contain material provided by third parties, is given in good faith and has been derived from sources believed to be accurate as at its issue date. While such material is published with necessary permission, and while all reasonable care has been taken to ensure that the information is complete and correct, to the maximum extent permitted by law neither PFSL nor any company in the Pendal group accepts any responsibility or liability for the accuracy or completeness of this information. Performance figures are calculated in accordance with the Financial Services Council (FSC) standards. Performance data (post-fee) assumes reinvestment of distributions and is calculated using exit prices, net of management costs. Performance data (pre-fee) is calculated by adding back management costs to the post-fee performance. Past performance is not a reliable indicator of future performance. Any projections are predictive only and should not be relied upon when making an investment decision or recommendation. Whilst we have used every effort to ensure that the assumptions on which the projections are based are reasonable, the projections may be based on incorrect assumptions or may not take into account known or unknown risks and uncertainties. The actual results may differ materially from these projections. For more information, please call Customer Relations on 1300 346 821 8am to 6pm (Sydney time) or visit our website www.pendalgroup.com

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