When people try to make sustainable investment decisions as self-decision-makers, reference is made everywhere to the ESG criteria of environmental protection, social responsibility and good corporate governance. An investor willing to invest makes a selection from a number of companies or sectors and invests in those securities that best meet ESG criteria. Ideally, they will have some sort of subjective compass to help them make their choice and guide them to a portfolio that represents their preferences and objectives.

ESG criteria direct the investor’s gaze in a certain direction. Unfortunately, this does not imply that the final decision for a company has been made yet, because the resulting amount of possible investments is still large. In practice, further selection mechanisms are then applied and companies are sought which do “no harm”, “the right thing” or, if the situation is not clear, “the least harm”.

Once the self-decision-maker has invested and made a portfolio fit his preferences and goals, it generates an immediate subjective return. Subjective returns are somewhat different from objective returns in the form of increases in value: After my analysis I finally decided to do good. This stands for itself and is not simply disproved by a negative objective return. Perhaps I simply have to wait a little longer until the hoped-for financial returns also develop positively.

Sustainable Portfolio Advisory Services

While a DIY investor may allow himself a subjective return, a bank that wants to use its tools to organise sustainable investment needs a different, more structured approach before it can give its customers the good feeling of a subjective return.

The Bank naturally asks itself to what extent it protects the environment, assumes social responsibility and lives good corporate governance. The Bank’s good corporate governance includes, for example, compliance with the regulatory rules on investment advice. According to these rules, the customer’s risk-bearing capacity and investment objectives must be recorded and taken into account in the recommendation. These individual customer parameters flow into the investment advisory process and ultimately modulate the selection of suitable ESG products.

Algorithms of portfolio analysis, which take into account the interactions of the securities contained in a portfolio, are of central importance for investment advice. The modern portfolio theory used for this purpose “processes” the above-mentioned parameters and can take into account additional control parameters such as model portfolio distributions or asset class yields as a secondary condition. As a result, the investor achieves an efficient portfolio that is expected to achieve the desired return with a minimum of risk.

Challenges due to additional constraints

If you want to make a sustainable change to existing advisory services, there are a number of starting points. A comparatively simple method is to assign a sustainability score to the recommendations at the end of an existing investment advisory process, thereby introducing an additional “sorting criterion” for the resulting recommendations. Further process adjustments may consist in the introduction of an asset class system that takes account of sustainability criteria. This is possible at the level of existing asset classes, or existing asset classes can be retained and supplemented with sustainable, alternative and thus customer-selectable twins.

Beyond these and other models of extending classic portfolio analysis to include sustainable aspects, it should not be forgotten that there are some challenges for which no standard solution exists. For example, a restriction of the available securities universe severely limits the possibilities for creating efficient portfolios. Beck and Layes (2019) reflect the implications of this aspect, along with others, in a highly recommended handbook article on the relationship between portfolio theory and sustainable investing.

The positive impact of sustainable corporate governance on a company’s share price is to be highlighted as an example. While the effect on the share is likely to be positive, the effect on the bond of the same company will be negative because the required bond interest rates are lower and thus less attractive for the investor. In the light of these and other methodological challenges, it does not seem surprising that there emerges a heterogeneous picture when comparing portfolios with and without ESG investments. Unfortunately, the meagre but nevertheless extensive data available makes it clear that there is still a great need for high-quality studies on this important topic.

Solutions for handling the increased complexity

The core competence of tetralog lies in the intelligent algorithmic mapping of the interaction between customer and institution. We have modular solutions for the integration of sustainable strategies and products into the consulting environment and look forward to exchange and cooperation.

München, October 2020

Dr. Lothar Jonitz

Related Links:

ESG in Investor Profiling

Andreas Beck, Gabriel Layes, Ethische Investments aus Sicht der Portfoliotheorie
in: Manfred Stüttgen (Hrsg.) Ethik von Banken und Finanzen, Theologischer Verlag Zürich; 2. Auflage (4. Januar 2019)
https://www.amazon.de/Ethik-Banken-Finanzen-Manfred-St%C3%BCttgen/dp/3290220370