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Set out ways to build ESG considerations into planning and constructing a portfolio

CFA® Level I · Portfolio Management · Basics of Portfolio Planning and Construction · PM.10.b

The idea

Environmental, social and governance considerations can enter portfolio planning at several points. The investment policy statement should record a client's ESG preferences, typically among the constraints or unique circumstances, so that managers are bound by them. Construction approaches differ in how they use ESG information. Negative or exclusionary screening removes sectors or companies, such as tobacco or weapons producers. Positive or best-in-class screening selects the highest-rated issuers within each sector, keeping sector weights near the benchmark. ESG integration adds material ESG factors to ordinary financial analysis. Thematic investing targets themes such as clean energy, and impact investing seeks measurable social or environmental benefit alongside a financial return. Active ownership, through engagement and proxy voting, tries to change company behaviour rather than avoid it. Screens shrink the investable universe, so they can raise tracking error against a conventional benchmark and alter the portfolio's risk profile.

A practice question

From the question bank, with the reason each wrong option is wrong.

A manager excludes all tobacco and weapons producers from a portfolio. This approach is:

  1. best-in-class selectionWhy not: That picks the strongest ESG performers within each sector rather than removing sectors.
  2. negative screening — correct
  3. active ownershipWhy not: Engagement and voting try to change companies, not remove them from the portfolio.

Negative, or exclusionary, screening removes whole sectors or companies from the investable universe on ESG grounds.

A harder one

A manager holds only the highest ESG-rated companies within each sector while keeping sector weights close to the benchmark. This approach is:

  1. best-in-class selection — correct
  2. impact investingWhy not: Impact investing targets measurable social or environmental outcomes, not relative ratings.
  3. negative screeningWhy not: Negative screening removes whole sectors, which would move weights away from the benchmark.

Positive or best-in-class screening chooses leaders within every sector, so the portfolio keeps broad sector exposure while tilting to stronger ESG performers.

The hardest tier

A client adds extensive exclusionary screens to a portfolio benchmarked to a broad equity index. The most likely consequence is:

  1. lower tracking error against the indexWhy not: Removing index constituents moves the portfolio away from the benchmark, not towards it.
  2. no change in the portfolio's risk profileWhy not: A smaller universe changes sector and factor exposures, so risk does change.
  3. higher tracking error against the index — correct

Excluding constituents shrinks the investable universe and creates sector and factor bets relative to the index, so returns deviate more from it.

In the app: 6 practice questions on this outcome, a narrated walkthrough with diagrams, spaced review that brings it back before you forget it.

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