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How do we incorporate ESG factors into our portfolios?

If you want to know more about how we incorporate ESG factors into our portfolios, please click on the different types of mandate:


1. Discretionary BL Funds mandate

Our management philosophy is built on five principles:

  1. A long-term approach focused on long-term asset protection and growth;
  2. An investment strategy drawn up independently in Luxembourg by our own managers;
  3. A firm belief in active management, which entails systematically seeking attractive opportunities in the financial markets;
  4. Only selecting high-quality companies (companies with a tangible competitive advantage, offering high levels of profitability and surplus cash, etc.);
  5. Paying particularly close attention to valuation levels

Our portfolios are built based on a long-term strategic allocation that sets the overall framework for the investments by combining different asset classes spread over different geographic regions and economic sectors. The low level of correlation between these asset classes ensures that the portfolio is sufficiently diversified and that risk is managed.

Discretionary BL Funds mandates are invested in funds managed by Banque de Luxembourg Investments (BLI).
These funds implement a fundamental approach within both the equity component and the bond component. 

1.1 Selecting companies for the equity funds: 

  • We use a resolutely entrepreneurial approach to identify companies that will generate high levels of profitability for many years to come. This long-term perspective, where the aim is to understand the various aspects of a company before investing and measure all associated risks, aligns very well with an ESG approach focused on environmental, social and governance criteria. 
  • The investment universe is made up of companies with transparent operations and clear business models. Our stock-picking methodology also relies on company valuation levels, since it is the price paid that determines the future return on any investment.
  • BLI’s ESG investment policy for the equity component is built on several separate yet interdependent pillars: 

1.1.1.    Exclusions: 

In accordance with the various international conventions, all companies involved in the production of controversial weapons, such as anti-personnel mines, cluster munitions, depleted uranium and white phosphorus munitions, as well as chemical and biological weapons, are completely excluded from Banque de Luxembourg Investments (BLI) funds. 

1.1.2.    Analysing controversies

Candidates for investment and companies held in the portfolio are subject to constant monitoring to identify noteworthy ESG events that could affect the company’s business model, its reputation and potentially therefore BLI’s investment case. This monitoring is conducted through the MSCI ESG Manager1  alert system, which flags up any controversies involving companies held by BLI. 

When a controversy arises, it is initially analysed on the basis of the controversy classifications assigned by MSCI (green, yellow, orange and red flags). Companies involved in the most severe controversies (in other words, those with a red flag), must be withdrawn from BLI’s investment universe within three months of their change in status2
Controversies with an orange flag (those classed as severe) undergo in-depth analysis drawing on various sources of information, including internal research, external research, the media and company information (in particular, Corporate Social Responsibility (CSR) reports). 

Moreover, ongoing controversies are monitored twice a year so as to include any relevant new information. 

1.1.3.    Integrating ESG factors

Fundamental analysis is an important stage in the process of identifying and quantifying the strength of a company’s competitive advantage as well as assessing its long-term potential. This analysis of the company’s fundamentals is based on historical profitability levels, the strength of the balance sheet, capital allocation and the management team’s past decisions. Determining potential available cashflow generation and carrying out a detailed assessment of the company’s secular growth drivers are also key stages in the analysis process. 

BLI integrates ESG risks and opportunities into its valuation model: hence, a company with a strong ESG profile will be assigned a higher intrinsic value, whereas a company lagging behind on ESG issues will be assigned a lower intrinsic value. This process is based on ESG ratings established by the data supplier MSCI ESG Research3 (AAA to CCC), where a rating of ‘A’ is considered neutral. As such, companies with a rating of A will not have their valuation model amended.  

 

1.1.4.    Active shareholding 

As part of its ESG investment policy and voting policy, BLI subscribes to the Institutional Shareholder Services Inc. (ISS) sustainable voting policy. This sustainability policy is designed to support shareholder resolutions based on standards that enhance long-term value for shareholders and stakeholders while also aligning the company’s interests with those of the wider society.

BLI also actively endeavours to engage with companies in an effort to improve the transparency of their ESG-related information and adjust their behaviour so as to encourage them to make changes or bring their practices into line with recognised international standards.

1.2.    Selecting issuers for the bond funds: 

  • Our bond investments focus on bonds from top quality issuers. The portfolio is constructed based on a set of criteria that include:

– assessment of the macroeconomic context;
– the quality of government fundamentals (solvency);
– the portfolio’s sensitivity to interest rate movements.
BLI applies two major approaches within its bond portfolios, either individually or in combination depending on the funds in question:

  • ESG optimisation: incorporation of ESG factors and non-financial elements in the analysis and selection process for individual issuers. The aim is for the average ESG score of each component (sovereign bonds and corporate bonds) to be higher than that of an index representing the relevant universe; 
  • Impact investing: investments made with a view to generating a positive social and/or environmental impact as well as a financial return. Several types of instrument with different characteristics are available: 

→ Liquid strategies: mainly green bonds;
→ Alternative strategies: microfinance, project financing, housing, etc. 

1.2.1.    Selecting sovereign issuers: 

  • BLI’s bond fund management team uses publicly available data to assess the ESG profile of the various sovereign issuers before assigning them a fundamental ESG score on a scale of 0 to 10. This public data comes from bodies such as the Food and Agriculture Organization of the United Nations, the International Labour Organization and the Global Health Observatory. 
  • However, this data is not updated frequently and it can be between two and ten years old. BLI has developed a proprietary methodology to compensate for this shortcoming and calculate a momentum score that reflects the ESG trajectory of the countries analysed. This methodology uses artificial intelligence and language processing technology to filter information flows (news, articles and more). 
  • A score per factor (environment, social and governance) is calculated for each country and then combined to give an overall ESG momentum score (from -2 to +2). This momentum score can push the fundamental ESG score higher or lower. 
  • The bond management team also assesses the impact of the portfolios on the UN Sustainable Development Goals (SDG). 

1.2.2.    Selecting corporate issuers: 

As in the equity component, ESG analysis of corporate issuers is conducted based on ESG scores developed by MSCI. The credit analysis process also places particular emphasis on any major controversies (those with a red flag in the MSCI classification4) that could affect the issuers in question, as well as whether or not the company adheres to the principles of the UN Global Compact.
Credit analysis involves comparing ratings based on financial data and ESG ratings to identify high-quality issuers. Where companies’ fundamental characteristics and returns are similar, the management team will prioritise the issuer with a higher ESG rating.


1.2.3.    Impact investing :

The green bond selection process seeks to exclude issues rated lower than BB+ and those where the issue amount is under USD 300 million. The next step is to carry out fundamental analysis of financial and sustainability factors. The aim is to ensure that issues actually target environmental and/or social projects. 
For microfinance investments, BLI relies on specialist external advisers who recommend eligible issues and conduct ongoing monitoring of the selected investments, while also taking into account the main investment criteria (minimum issue amount, rating, project type, region, etc.). 

1.3.     ESG approach at portfolio level: 

To supplement the ESG approach used for each of the funds that make up the managed portfolio, quantitative analysis is also conducted. We use MSCI ESG Manager5 scores (between 0 and 10) and then weight these scores according to their weighting in the portfolio to calculate a score for the portfolio as a whole. This is then converted into a rating between AAA and CCC, using the MSCI ESG Manager scale. 
 


Our aim is for the average rating of the portfolio to be BBB or higher, confirming above-average ESG positioning.


2. Discretionary socially responsible funds mandate

Discretionary socially responsible funds mandates invest in funds and trackers with embedded ESG investment strategies. 
In-depth qualitative analysis is carried out to assess the solidity of the management process, and the ESG approach in particular. To that end, various approaches may be applied to the portfolio: 


-    The best-in-class approach, which seeks to select companies with the best environmental, social and governance practices in their sector or industry; 
-    The ESG integration approach, which places equal emphasis on financial and non-financial criteria;
-    The thematic approach, which targets a specific area, such as the environment, water management or gender parity;
-    Impact investing, which aims to generate a positive environmental or social impact as well as financial performance.

The key features of impact investing are its intentionality and the measurability of the impact. 

In addition to qualitative analysis of funds’ management processes, we try to determine whether the management company itself also behaves in a thoughtful, sustainable way. To that end, our team of analysts have put together a questionnaire that allows them to understand the extent to which the management company under review has weighed up sustainability risks and opportunities. This questionnaire serves as a point of reference when identifying the management company’s positioning on sustainable investment, its philosophy and the concrete measures it has implemented. Our system also includes a quantitative element; in other words, it relies on external ratings of the various vehicles included as part of the discretionary socially responsible funds mandate solution. To do so, we use MSCI ESG scores, which rate the various funds according to ESG risk on a scale of 1 to 10. Given that MSCI ESG does not differentiate between green bonds and other types of bond, we award a bonus to funds with exposure to green bonds. 

We then weight these scores by the vehicles’ weightings in the portfolio to calculate a score for the portfolio as a whole. This score is converted into a rating between CCC and AAA, where AAA is the best. Our aim is for this average portfolio rating to be A or higher, demonstrating that the portfolio has a strong ESG profile. 

 


3. Discretionary external funds mandate

For this type of mandate, we rely on external ratings of the various vehicles included as part of the discretionary external funds mandate solution. We use MSCI ESG scores6, which rate the various funds according to ESG risk on a scale of 1 to 10. 
We then weight these scores by the vehicles’ weightings in the portfolio to calculate a score for the portfolio as a whole. This score is converted into a rating between CCC and AAA, where AAA is the best. 

 

Our aim is for this average portfolio rating to be BBB or higher, confirming above-average ESG positioning.


4. Direct lines mandate 

The discretionary direct lines mandate is built on two fundamental principles:

  • Diversification (across asset classes, sectors and geographical regions): the portfolio construction process entails combining decorrelated asset classes, so that the total portfolio risk is lower than the sum of the risks of the various assets (or instruments) within it. This serves to minimise the risk per unit of return, or maximise the return per unit of risk. We also focus on the relative valuation levels of the various asset classes. 
  • Selecting high-quality securities :

- We use a resolutely entrepreneurial approach to identify companies that will generate high levels of profitability for many years to come. This long-term perspective, where the aim is to understand the various aspects of a company before investing so as to measure all associated risks, aligns very well with an ESG approach.

- The investment universe is made up of companies with transparent operations and clear business models. Our stock-picking methodology also relies on company valuation levels, since it is the price paid that determines the future return on any investment.

4.1.     Equities

The ESG investment policy for the equity component is built on several separate yet interdependent pillars:

4.1.1.    Exclusions: 


In accordance with the various international conventions, all companies involved in the production of controversial weapons, such as anti-personnel mines, cluster munitions, depleted uranium and white phosphorus munitions, as well as chemical and biological weapons, are completely excluded.

4.1.2.    Integrating ESG factors


Fundamental analysis is at the heart of the management process, allowing us to identify and quantify the strength of a company’s competitive advantage and assess its long-term potential. 

This analysis of the company’s fundamentals is based on historical profitability levels, the strength of the balance sheet, capital allocation and the management team’s past decisions. Determining potential available cashflow generation and carrying out a detailed assessment of the company’s secular growth drivers are also key stages in the analysis process.

For our valuation model, we use a standardised Dividend Discount Model (DDM) across all the securities in our universe, regularly supplemented with Discounted Cash Flows (DCF) analysis allowing us to determine each company’s intrinsic value. Calculating this intrinsic value provides a point of reference so that we can avoid paying too much for a company. It also serves as a guide in the purchasing and selling process. This characteristic feature of our approach allows us to better understand the risks associated with an investment. 


Our models integrate both ESG risks and opportunities (through the discount rate): hence, a company with a strong ESG profile will be assigned a higher intrinsic value, whereas a company lagging behind on ESG issues will be assigned a lower intrinsic value. This process is based on ESG ratings established by the data supplier MSCI ESG Research7 (AAA to CCC), where a rating of ‘A’ is considered neutral. As such, companies with a rating of A will not have their valuation model amended.  

 

Integrating ESG factors into the valuation process, investment decisions and hence final portfolio allocations is fully in line with our fundamental approach of selecting securities issued by high-quality companies through a long-term entrepreneurial approach. Taking non-financial data into account paints an even more detailed picture of all risks and opportunities associated with candidates for investment and therefore enables us to take even more well-informed investment decisions.

4.1.3.    Analysing controversies

Additionally, we conduct ongoing controversy monitoring on the companies held in the portfolio. An ESG controversy may be defined as a real-world incident or situation in which a company is accused of behaviour with an adverse impact on the various stakeholders (employees, suppliers, local communities, the environment, shareholders, etc.).

These events could affect the company’s business model, its reputation and potentially therefore the investment case. We identify such controversies by using the MSCI ESG Manager platform, which provides daily alerts on any noteworthy controversies involving the companies held in the portfolio. 

We also pay close attention to any controversies involving companies when we analyse candidates for investment. The aim of this is to assess the severity of the adverse impact of each situation. 

4.2.    Bonds

Incorporation of ESG factors and non-financial elements in the analysis and selection process for individual issuers.

4.3.    ESG approach at portfolio level

To supplement the ESG approach used for each of the instruments that make up the managed portfolio, quantitative analysis is also conducted. We use MSCI ESG Manager scores (between 0 and 10) and then weight these scores according to their weighting in the portfolio to calculate a score for the portfolio as a whole. This is then converted into a rating between AAA and CCC, using the MSCI ESG Manager scale. 

 

Our aim is for the average rating of the portfolio to be BBB or higher, confirming above-average ESG positioning.

 

1The full methodology is available at www.msci.com

2However, the relevant fund manager does have the option to submit a request to the SRI Committee explaining the reasons why he or she believes that the company should still be eligible for investment. Approval can be granted by means of a vote with a simple majority. The fund manager does not have the right to cast a vote.

3 5 6 7 8The full methodology is available at www.msci.com

4The full methodology is available at www.msci.com


CTA contact Melanie Mortier

For more information

Melanie Mortier
Senior Portfolio Manager

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