Ask the Expert with Northern Trust Asset Management: Understanding the ESG risks within your portfolio

In our latest Special Report, Chipo Muwowo, spoke to the experts from Northern Trust Asset Management about understanding the ESG risks within your portfolio.

Michael Hunstad, Chief Investment Officer for Global Equities at Northern Trust Asset Management, serves on the asset management executive group, and leads all equity portfolio management and research for quantitative, index and tax-advantaged strategies.

Julie Moret, Global Head of Sustainable Investing and Stewardship for Northern Trust Asset Management, guides the creation of long-term investment value for clients through environmental, social and governance (ESG) risk management, effective engagement, and proxy voting.

Chipo: What was the rationale for producing a ‘Risk Report’ with a special focus on ESG?

Mike Hunstad: In 2021, more than $650 billion flowed into ESG-related equity strategies, about 10% of the total equity flow for the year. As interest in ESG grew, the ESG-related flows increased, causing ESG criteria to account for an increasingly larger portion of total market risk and return. This trend has implications for all investors, both those that have intentional ESG exposure and those that don’t. All investors should have a good understanding of the potential implications of ESG on their total portfolio.

''Our analysis provides an analytical framework that helps investors gain clarity on the impact of ESG exposure on their portfolios, whether they were intentional or not.''

We can examine the implications of ESG on underlying portfolio characteristics and validate whether they’re getting what they desire out of ESG investing.

Chipo: Broadly speaking, how would you say ESG is impacting portfolio risk?

Mike Hunstad: Equity markets comprise a variety of risks, some are compensated and others like sector, currency, and country bias are not. Our analysis found that among high-ESG portfolios, 40% of active risk was not only uncompensated, it was also unnecessary as it didn’t add to the portfolio’s total ESG exposure. This raises the question of whether ESG investors are efficiently garnering intended ESG risk exposure or, instead, have large swaths of uncompensated risk in their portfolios.

High levels of uncompensated risk would be fine if it were eliminated through diversification. However, that is not happening. In fact, we often see the opposite, worst-case scenario: diversification lowers compensated risk and even ESG content while leaving uncompensated exposures.

This is an important concept. It’s not just about adding ESG strategies to a portfolio, but about how you bring those strategies together in aggregate.

Chipo: Less than half of active risk in portfolios with higher ESG-ratings came from ESG-related sources. Why should this concern investors?

Mike Hunstad: On average, only 40% of the active risk of ESG portfolios could be attributed to an ESG bias. The remaining 60% was from other non-ESG sources. Of this, 20% came from compensated, non-ESG risks like higher quality and lower volatility biases, and 40% from uncompensated sources. Regardless of your view on the return implications of ESG, the bulk of your active risk could come from uncompensated, non-ESG sources. That’s a huge concern.

Chipo: Which research finding surprised you the most and why?

Julie Moret: It was rather interesting to see the increased correlations among ESG and compensated style factors.

''Prior to 2020, the relationships between ESG and these style factors were relatively muted, meaning high degrees of potential style factor biases didn’t necessarily add high magnitude of unintended risk exposures. However, this is no longer the case.''

This divergence, in the relationship between some of these compensated style factors and ESG, really underscores how important it is to understand these changing relationships, and to ensure that portfolios don’t load up on ESG exposure at the expense of potentially introducing unintended style factor biases at the same time.

The article continues on page 10 of our Special Report: 'Portfolio Risk and the ESG Effect: Pulling back the veil'