Building a sustainable portfolio

Building a sustainable portfolio

We build a fully sustainable portfolio following a disciplined asset allocation and portfolio construction process.

What you need to know

Introduction

At Quintet, we believe that incorporating material sustainability factors can improve the investment decision-making process. We apply our sustainable investing philosophy to build a fully sustainable and diversified portfolio.

We believe the best way to achieve financial goals is by investing in financial markets with a long time horizon. It is also critical that the portfolio reflects investors’ risk appetite. Therefore, we define a set of long-term asset allocations that cater for a range of risk tolerances, from low to high.

Asset allocation is a key driver of the portfolio returns. We ensure our allocation represents our two core investment beliefs – global diversification and sustainable investing.

To establish a fully sustainable portfolio, we go through a well-defined four-step process (figure 1).


Step 1: Define the asset class universe

The first step is to define which asset classes are investable. We do this by considering liquidity, accessibility and sustainability. We also aim to avoid significant risk/return deviations between sustainable asset classes and their conventional counterparts, whilst capturing opportunities presented by sustainable approaches. Our universe only includes asset classes that can be implemented in the portfolio in a sustainable way.

As a result, diversified commodities are typically excluded from our asset universe, with the exception of gold, for which recycled gold presents a viable sustainable equivalent. Generally, we view commodities as having little value to add to a multi-asset portfolio. Most provide no cash flows, and offer limited diversification benefits. From a sustainability perspective, commodities present significant negative impacts on the environment and society. For example:

Step 2: Establish the asset allocation

This step defines a target strategic asset allocation (SAA) for each client risk profile and reference currency.

Capital market assumptions are key when constructing optimal portfolios. They include 10-year estimates of future risks, returns and correlations for all of the asset classes in our universe.

Optimisation models are then used to find the most efficient allocation that offers the highest expected return for a given level of risk (figure 2).

Sustainable factors such as energy transition, income inequality, diversity and inclusion can be factored in macro underpinnings of the models – namely inflation, interest rates, productivity and economic growth. For example:

Step 3: Map sustainable assets

This step brings the SAA to life by mapping asset classes to their sustainable equivalents (figure 3). We utilise Quintet’s sustainable toolkit comprising of leaders, improvers, themes and dedicated assets to construct a sustainable portfolio. The mapping guides our implementation of a sustainable portfolio that offers full global diversification, so we ensure it is structured and robust.

Some conventional asset classes can be entirely substituted by a sustainable counterpart. For example, developed market government bonds can be substituted by multilateral development bank (MDB) bonds. MDB bonds enjoy high credit ratings because of the MDBs’ reliable subscribed capital and high-quality loan portfolio. With a close correlation to AAA-rated government bonds, MDB bonds can replace similarly rated government bonds exposure in an allocation framework. For instance, MDB bonds issued in USD have tracked the performance of US Treasuries well (figure 4). From a sustainability perspective, MDB bonds deliver positive impacts as each dollar is used to fund sustainable development projects, such as building new roads and providing clean water to communities.

For other asset classes a substitution approach may not be the preferred choice. In the same way that conventional equity investing can focus on growth or value, we deploy sustainable strategies including leaders, improvers and thematic for our equity exposure. The leaders approach – choosing companies that are performing well on sustainability issues – is a well-established sustainable investing strategy with a multi-decade track record. As such, a large number of passive solutions as well as regional equity applications exist. We use leaders for regional equities. On the other hand, improvers – choosing companies that are improving their sustainability profiles – is a relatively new investment approach. Globally-focused applications are more established than regional implementations. Themes are inherently global as innovation can occur in any geography and has global consequences. Themes focus on companies that are creating the sustainable products and services of the future economy.

Step 4: Select instruments

The final step populates our SAAs with investment products. We aim for the portfolio construction to be robust, logical and structured.

The instrument selection operates a clear hierarchy. First, instrument selection should reflect both the desired asset allocation and our chosen sustainable investing philosophy. Second, our starting point is to seek passive implementation. Active strategies entail outsourcing the investment decisions to a third party and are therefore predominantly deployed in sub-asset classes that are less developed and can benefit from either market inefficiency or an active manager’s access to liquidity.

Third, we take care to limit unwanted portfolio biases that may arise from our sustainable implementation. For example, within fixed income, sustainable asset classes can have a different duration to conventional indices. If this is not managed appropriately our portfolios may under or outperform in periods of rising (or falling) interest rates.

As per the above, to represent EUR government bonds we use MDB bonds and sovereign green bonds. The EUR government bond index has a duration of 8 years. However, the (USD, EUR- hedged) MDB index has a duration of just 3.6 years, while the EUR sovereign green bond index has a duration of 11.1 years. In our portfolios we therefore seek to blend MDB bonds and sovereign green bonds to achieve a duration that is close to benchmark (figure 5).

Conclusion

By integrating sustainability at every step of the investment process, we build a truly sustainable portfolio that reflects our investment beliefs of global diversification and sustainable investing. We exclude commodities when defining the asset class universe, with the exception of gold. Sustainable considerations can be factored into macro underpinnings of capital market assumptions when estimating asset classes’ long-term risks and returns. The asset allocation is then brought to life by mapping sustainable equivalents to each asset class. Finally, a robust implementation process ensures an accurate reflection of the asset allocation and the sustainability of instruments.

Authors:

This document has been prepared by Quintet Private Bank (Europe) S.A. The statements and views expressed in this document – based upon information from sources believed to be reliable – are those of Quintet Private Bank (Europe) S.A. as of 6 June 2022, and are subject to change. This document is of a general nature and does not constitute legal, accounting, tax or investment advice. All investors should keep in mind that past performance is no indication of future performance, and that the value of investments may go up or down. Changes in exchange rates may also cause the value of underlying investments to go up or down.

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