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## A new attribution approach to enhance ESG transparency

#### Financial institutions, traditionally focused on maximizing returns, now acknowledge that their capital allocation decisions have real-world implications, from carbon emissions to labor practices and board diversity. This shift has made integrating ESG factors into investment strategies a crucial aspect of portfolio management.

To effectively navigate this evolving landscape, investors rely on performance attribution to assess whether their decisions align with initial expectations. This process helps determine whether investment choices met financial and ESG goals or if unforeseen variables influenced the outcome. For example, if a portfolio aims to outperform a benchmark in terms of carbon emissions or achieve net zero by a specific year, performance attribution helps investors analyze both financial returns and environmental impact, creating a continuous feedback loop to refine decision-making.

### Building an ESG attribution framework

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Regulatory frameworks, such as the EU’s Sustainable Finance Disclosure Regulation, further reinforce the importance of ESG transparency by requiring funds that incorporate ESG considerations to disclose their practices and results. As a response to this growing need, Ortec Finance and MN - a leading Dutch fiduciary asset manager - have developed an attribution model that enables investors to compare their portfolio’s performance against benchmarks for both financial and non-financial metrics, such as carbon emissions and ESG factor scores.

The model not only attributes ESG metrics to specific investment decisions but also captures both intended and unintended consequences. Initial testing with real data from two client portfolios revealed that exclusion policies significantly reduced financed emissions, while weight caps on certain exposures designed to limit financial volatility had unintended negative impacts on carbon footprints.

An important next step for an ESG attribution calculation is to analyse the ESG performance of the portfolio over time and attribute the performance of the portfolio compared to the benchmark to different investment decisions.

In a recently released whitepaper, co-authored by Ortec Finance and MN, we explain this new ESG attribution framework in more detail.

[Download](https://www.ortecfinance.com/en/insights/research/esg-attribution-the-development-of-an-attribution-model) the whitepaper or contact us today if you want to speak to one of our experts.

Contact
### Sam Radford
Medior Business Specialist Investment Performance

Email: [Sam.Radford@ortec-finance.com](mailto:Sam.Radford@ortec-finance.com)

ESG Attribution – The development of an attribution model

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*By Chris Hay, Vice President, Sustainability Solutions, BlueOnion*

### Introduction

Responsible investing is at a critical crossroads. The European Securities and Markets Authority (ESMA) recently revealed that over 40% of ESG-labeled investment funds in the EU may need to change names or sell assets to comply with new anti-greenwashing rules. 

Thousands of ESG-labeled funds are still invested in companies exceeding fossil fuel revenue thresholds. At the same time, hundreds more are exposed to controversial weapons, tobacco, and businesses that harm the world.

These findings underscore the urgent need for precisely classifying green financial products. Financial institutions risk losing investor trust, facing regulatory penalties, and failing to contribute to real sustainability progress without standardized criteria. Proper classification ensures that green-labeled funds align with ESG objectives, reinforcing credibility and investment transparency.

One of the most widely adopted frameworks for green classification is the EU Sustainable Finance Disclosure Regulation (SFDR), which categorizes funds into Article 6 (no sustainability focus), Article 8 (promoting ESG characteristics), and Article 9 (targeting measurable sustainability impact). Beyond classification, the rise of transition finance offers a new investment opportunity by supporting companies actively shifting toward greener business models rather than focusing only on already sustainable ones.

### Regulation as a driver

Regulatory compliance and transparency are central to classifying green financial products. The SFDR framework requires asset managers to disclose how sustainability risks are integrated into investment decisions. Without a transparent classification system, the market risks become fragmented, with inconsistent sustainability claims leading to investor confusion and regulatory scrutiny.

Beyond regulatory obligations, investor trust is at stake. Institutional and retail investors increasingly demand sustainable investment options with genuine ESG commitments. Misclassified funds that fail to meet these expectations can suffer reputational damage and potential legal consequences. Asset managers can reinforce credibility and attract responsible investors by ensuring that funds marketed as sustainable adhere to measurable ESG criteria.

Risk management also plays a crucial role in green product classification. The SFDR mandates that asset managers consider Principal Adverse Impact (PAI) indicators, which measure whether a fund’s investments cause significant harm to society or the environment. Under these guidelines, Article 8 funds must ensure that their investee companies avoid major ESG controversies, such as involvement in fossil fuels, weapons, or human rights violations, while maintaining a minimum ESG score. Article 9 funds face even stricter requirements, ensuring that at least half of their portfolio actively contributes to sustainability goals while doing no significant harm.

Studies have found that nearly half of ESG funds in the EU fail to meet Paris-Aligned Benchmark (PAB) exclusion criteria, with fossil fuel investments being the most common issue. Thousands of funds continue to invest in companies exceeding the 10% oil revenue limit, while hundreds of others are exposed to controversial weapons, tobacco, and high-emission energy generation. Financial institutions may unknowingly expose themselves to sustainability risks and non-compliance without proper classification.

### Greenwashing Mitigation

Greenwashing—where financial products misrepresent their ESG credentials—has emerged as one of the most significant threats to sustainable finance—asset managers who fail to back up sustainability claims with evidence risk regulatory scrutiny and damage investor confidence. Superficial ESG integration, misleading marketing claims, and a compliance-driven "box-ticking" approach undermine the industry's credibility and can lead to regulatory penalties.

Asset managers must adopt an evidence-based approach to sustainability classification to mitigate these risks. This requires going beyond basic ESG disclosures and conducting in-depth assessments of investee companies. A key aspect of this due diligence involves analyzing capital expenditures (CAPEX) and operational expenditures (OPEX) to determine whether companies genuinely invest in green initiatives rather than making superficial sustainability claims.

Ongoing monitoring is also critical in preventing greenwashing. A company that meets sustainability criteria today may not maintain those standards in the future. Regular reviews of investee companies ensure that funds remain aligned with their stated ESG objectives and do not become vulnerable to sustainability downgrades or reputational risks.

Stakeholder engagement further reinforces credibility in sustainable investing. Asset managers should actively engage with investee companies to ensure that they are not merely making sustainability commitments on paper but are taking concrete steps toward measurable improvements. This engagement can include setting specific ESG performance targets, participating in ESG-related shareholder resolutions, and collaborating with companies to refine sustainability strategies. Without active engagement, ESG commitments risk becoming empty promises rather than catalysts for real change.

### Turning Transition into Profits

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Traditional green investing has primarily focused on companies that already meet high ESG standards. However, transition finance presents a new opportunity by supporting businesses actively shifting toward greener practices. Many industries—particularly those in high-emission sectors such as energy and manufacturing—are undergoing significant transformations to align with sustainability goals. Instead of divesting from these industries altogether, asset managers can support and accelerate their transition.

Evaluating a company’s transition readiness requires a deeper level of analysis. Assessing where a company stands today is not enough; what matters is whether it has a credible plan to become more sustainable. This includes tracking science-based targets for carbon reduction, commitments to net-zero pathways, and improvements in PAI indicators over time.

For example, a European steel manufacturer, traditionally reliant on coal, has committed to net-zero emissions by 2040. Over the past three years, it has reallocated 30% of its CAPEX toward green hydrogen technology. Asset managers tracking CAPEX and OPEX shifts can verify real progress and differentiate between genuine transition leaders and companies making empty sustainability claims.

By incorporating finance into their sustainability strategies, banks, and asset managers can generate long-term value while driving real environmental and social progress. This approach expands the pool of investment opportunities beyond companies already ESG leaders, allowing financial institutions to play a more active role in shaping the sustainability landscape.

### Safeguarding Banks and Asset Managers Against Unintended Greenwashing

Companies such as BlueOnion specialize in detecting greenwashing risks and monitoring transition investments using an advanced data intelligence platform. 
Banks and asset managers can validate a fund's alignment against Article 8 and Article 9 metrics through an evidence-based SFDR classification methodology. The fund’s PAI scores also ensure that funds avoid significant ESG risks and meet sustainability criteria.

For asset managers financing transition trends, demonstrating that portfolio companies are making measurable, sustainable progress is crucial. Analyzing CAPEX, OPEX, and sustainability-linked revenues offers concrete evidence of a company's transition strategy. This approach strengthens the verification process and fosters active engagement with underperforming investees, enabling asset managers to encourage ESG improvements instead of resorting to premature divestment.

### The Best of Both Worlds:

As regulatory scrutiny of ESG investing intensifies, financial institutions face the dual challenge of ensuring compliance with evidence-based standards while maintaining investor trust and mitigating greenwashing risks. Yet, effective ESG classification goes beyond regulatory obligations—it unlocks opportunities in transition finance to support companies genuinely striving for sustainability.

Advanced ESG intelligence tools help asset managers address the challenges of regulatory compliance and sustainability integration. By utilizing real-time analytics, comprehensive ESG insights, and compliance support, these tools enable financial institutions to develop transparent, sustainable investment portfolios while contributing to long-term positive impacts across the financial sector.

#### [Discover how BlueOnion can be your partner to tackle greenwashing risks—request a demo today.](https://outlook.office.com/bookwithme/user/4aac47fbc3da42d9b66c839edcbe429d%40blueonion.today/meetingtype/s33aHo3azkGS0dCzQkbP-w2?anonymous)



ESG Under Fire: Unlocking Credibility with Green Classification

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# Create a visual map of your financial future

Are you saving money without a clear purpose? And putting off investing because you don’t know where to start?

•	**Give meaning** to your investments by connecting them to your life goals.

•	**Break down your journey** into clear, manageable steps.

•	**Make decisions** that align with what matters to you.

Ready to take the first step?

**[Define your goals](https://amundi-global-retail.intramundi.com/retail/new-investing-start-here-six-step-guide)**
 
# Wondering which investments actually match your goals?

With countless investment options available, choosing the **right** ones can feel challenging. Investment decisions deserve careful thought.

We cut through the complexity and help you **match investments** to your goals.

Let's clear the path to your investment decisions.
 
# Understand the risk-return connection

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# Factor timelines in your decision

Your investment horizon significantly influences which solutions make sense for you:

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### Diversify your investments

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# Evaluate different options

There are many options for how you can best build your portfolio:

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# From Knowledge to Action

Investment knowledge is your foundation, but action is what builds your future.

These key principles help you better understand your options and have productive conversations with your financial advisor. Today's choices build tomorrow's success.

 

##### Important and Legal Information
This document is issued by Amundi Singapore Limited (Company Registration No. 198900774E) who is regulated by the Monetary Authority of Singapore. 

This document is for information purposes only, is not a recommendation, financial analysis or an investment advice and does not constitute a solicitation, invitation or offer to purchase or sell any product. The information contained in this document is intended for general circulation without taking into account the specific investment objectives, financial situation or particular needs of any particular person. 

The information contained in this document is as at February 2025 except where otherwise stated. The information contained in this document has been obtained from sources believed to be reliable but has not been independently verified, although Amundi and its affiliated companies (collectively “Amundi”) believe it to be fair and not misleading. Opinions expressed in this document are subject to change without notice. Amundi does not accept liability whatsoever whether direct or indirect that may arise from the use of information contained in this document. Amundi and its associates, directors, connected parties and/or employees may from time to time have interests and/or underwriting commitments in the securities mentioned in this document.

**Past performance and any forecasts made are not necessarily indicative of the future results**. Any forecast, projection or target is indicative only and is not guaranteed in any way. All investments involve risks and the amount received from such investments may be less than the original invested amount. Amundi does not guarantee that all risks associated to the securities mentioned herein have been identified, nor does it provide advice as to whether you should enter into any transaction.

This document is solely for issue in permitted jurisdictions and to persons who may receive it without breaching applicable legal or regulatory requirements. The information contained in this document shall not, without prior written approval of Amundi Singapore Limited, be copied, reproduced, modified, or distributed, to any third person or entity in any country.
This document is not for distribution and does not constitute an offer to sell or the solicitation of any offer to buy any securities or services in the United States or in any of its territories or possessions subject to its jurisdiction to or for the benefit of any U.S. Person (as this term is defined in SEC Regulation S under the U.S. Securities Act of 1933). 

**This document has not been reviewed by the Monetary Authority of Singapore.**

How can Goal-Based Investing help you with retirement?

How To Build Wealth ft. Earn Your Leisure

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CIO VIEWS. **Sonal Desai**, Ph.D. Chief Investment Officer, Franklin Templeton, Fixed Income

Two driving forces are now simultaneously pushing in the direction of higher long-term real interest rates. While investors and commentators often tend to conflate the two, I think it is useful instead to distinguish them clearly. They are rising investment, and persistently large fiscal deficits.

A new trend toward stronger investment has emerged and is likely to endure for the next several years, driven by a number of important priorities: (a) there is a need to make up for past under-investment in infrastructure, including traditional infrastructure as well as digital infrastructure. The American Society of Civil Engineers’ latest report assigns a failing grade to overall US infrastructure (not for the first time);¹ (b) rising geopolitical tensions necessitate an increase in defense spending across Western countries; (c) growing interest in the potential of Artificial Intelligence calls for new investment in the necessary hardware (notably semiconductors), software and energy; (d) the green energy transition requires more investment to boost the role of renewables; and (e) manufacturing companies need to continue to invest in new technologies, which includes making supply chains more resilient.

Not all of this will result in rapid gains in productivity. For example, while the green energy transition is a very important goal,
a lot of the required investment will not increase productivity growth in the short and medium run. Because it consists of replacing existing capital, it increases current economic growth via higher expenditures, but it does not raise productivity—much like rebuilding existing structures after they’ve been destroyed by a hurricane. The economist Jean Pisani-Ferry, in a recent report for the French government, has estimated that in fact investment in the green transition will likely reduce productivity growth by a quarter percentage point per year for the next several years. (The report also warns that the green transition increases inflation risks over the next decade).²

However, the bulk of investment should over time result in faster productivity growth (the acceleration in US productivity during 2023 already gives hope, even if the weak first quarter of this year counsels caution). Faster productivity growth should in turn drive faster real economic growth, reversing one of the key arguments of the Secular Stagnation theory,³ and implying a higher equilibrium interest rate in the long run.

Moreover, for a given level of savings, stronger investment also eliminates or reduces the “savings glut,” again pointing to higher real interest rates. The government has and will carry out some of this, and investment is therefore often mentioned in the same breath as wider fiscal deficits. But the two need not go hand in hand. Governments could offset stronger public investment with a reduction in less productive public spending (or with higher taxes). Moreover, a significant portion of governments’ investment often turns out to be ineffective at raising productivity—the private sector has consistently been a much better allocator of capital.

The United States has experienced a persistent loosening of fiscal policy that goes well beyond the country’s public investment efforts. Therefore, quite separately from lifting investment, persistent large fiscal deficits now play their own important role in shaping the outlook for interest rates. The US government has been running a massively loose fiscal policy for a very long time now: The US fiscal deficit has averaged close to 8% of gross domestic product (GDP) for the last six years. It averaged just under 6% of GDP during 2022-2023 even as economic growth boomed, and the Congressional Budget Office (CBO) projects the deficit to average 5.5% of GDP for the next five years and then to rise further into the future. As a consequence of persistent large deficits, the debt stock has risen sharply.

A decade ago, publicly held federal debt was about 70%; now it is close to 100% of GDP and will keep rising rapidly if deficits remain as large as the CBO forecasts.

The need to fund large fiscal deficits year after year means a lot of pressure on bond supply. For a given level of demand, this tends to push bond prices down and interest rates up. Moreover, a large fiscal deficit, growing debt and high interest rates create a vicious spiral that makes it harder and harder to reduce the deficit. Currently, non-defense discretionary expenditures account for less than one-sixth of the US budget (15% of total expenditures). Interest expenditures meanwhile keep rising—they averaged just 1.5 % of GDP in the last 10 years. The CBO projects that they will average 3.5 % of GDP for the next 10 years, more than double, and will grow larger than non-defense discretionary spending by 2025. This would leave very few resources for education, infrastructure investment, transportation, homeland security and the like.

And, the underlying CBO forecasts are probably conservative: They assume that the interest rate on federal debt will remain under 3.5% over the next decade. To put this assumption in perspective, consider that through the 1990s up to the eve of the global financial crisis (GFC)—in other words before the more recent period of ultra-loose monetary policy—the interest rate on US government debt averaged close to 6%. If the average interest rate on debt were to rise even just one percentage point above the CBO assumption (still well below the pre-GFC average), within 10 years interest expenditures would be more than double their current level.

Any way you cut it, bringing the US budget deficit under control will require very serious efforts, which in my view seems implausible in the current political climate. Meanwhile, loose fiscal policy will likely continue to put upward pressure on interest rates.

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I have been arguing for some time that equilibrium real interest rates are likely much higher than the markets and the Federal Reserve (Fed) still seem to assume—with the neutral fed funds rate above 4% rather than at the Fed’s current forecast of about 2.5%, and 10-year US Treasury yields correspondingly higher. The confluence of loose fiscal policy and a rising investment trend can only strengthen my conviction in this higher interest rates outlook.


[1] Source: “2021 Report Card for America’s Infrastructure.” American Society of Civil Engineers, 2021.

[2] Source: Pisani-Ferry, Jean and Mahfouz, Selma. “The economic implications of climate action.” Republique Francaise. November 2023. There is no assurance that any estimate, forecast or projection will be realized.

[3] Secular Stagnation theory suggests that an economy can experience persistent low GDP growth, low interest rates, and high long-term unemployment due to a deficiency in aggregate demand.


On My Mind The twin roots of rising rates

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##### By Monica Defend, Head of Amundi Institute 

There’s a growing global consensus on the urgent need to combat climate change. But governments’ uncoordinated reactions to energy price spikes in the past year showed that a successful and orderly transition to a greener economy is far from guaranteed. A ‘disorderly’ transition, driven by disjointed policy actions therefore weighs more heavily on our baseline scenario for our capital market assumptions, our long-term asset class forecast and strategic allocations for the year. Limiting the rise in temperatures over the net zero 2050 horizon is the shared endgame, but disruptive themes will likely profoundly affect the real economy and financial markets.

In the near term, the energy transition could provoke bouts of inflation due to higher carbon and commodity prices. But we believe price pressures won’t be persistent. A more lasting impact may be seen from a shift away from fossil fuels, technological changes, and initially lower productivity. This could dent domestic demand and may mean economic growth is more subdued in the medium to long term.

Central banks will likely be cautious about running down their balance sheets, but aggressively use short-term interest rates to counteract inflationary swings. Monetary policy will try to prevent debt levels from becoming explosive, while keeping long-term rates under control. Central banks’ balance sheets will therefore stay well above pre-Covid levels. Sectors that are most closely linked with the green transition should be the biggest beneficiaries from policymakers’ support - a sort of ‘green’ quantitative easing.

Recycling carbon tax revenues into climate-related activities that help households and firms may also offset part of the transition’s negative impact on growth. This could translate into higher future productivity, while helping to mitigate social costs and pushback from the most vulnerable parts of the population. Managing the social costs will likely be key to the transition, as the effects of climate change are felt unevenly across communities.

A more inclusive growth model could be promoted by rebalancing the national share of income towards labour, without significantly affecting the economy. Higher wages will compress corporate profit margins. But higher disposable income will buoy household consumption and should help to support companies’ revenue.  We estimate that a 7% increase in the labour share of income deriving from higher wages can be accompanied by less than a 10% decrease in cumulated profits over the next 20 years in most developed countries.

New legislation aimed at decarbonising energy supply will affect emerging and frontier economies the most, while more developed and less carbon-intensive economies will cope by diversifying the composition of their exports. Investment plans should therefore accompany the phasing-out of fossil fuels in countries and sectors where their legacy is strongest.

In our view, investors should therefore factor in the implications of a shift towards a net zero world, driven by new policies, technology, and changing consumer preferences. The climate transition presents both risks and opportunities for investors, and energy transition themes will remain in the limelight for the foreseeable future. 

In an era of more urgent but less coordinated transition, we expect equity returns will be lower over the next ten years than in the past decade. But emerging markets, particularly Chinese and Indian stocks, may offer interesting opportunities, while the US remains favoured among developed markets. From a sectoral perspective, we believe the leaders in the green transition will be favoured together with Information Technology, and the outlook for value investing looks positive.

After a lost decade, bonds are returning to their long-term trend. This is reviving their role as a potential portfolio risk diversifier, although we anticipate higher volatility given greater uncertainty and a weaker economic outlook. Investment grade credit could benefit from higher government bond valuations.  Emerging market bonds can offer higher yields, but might be challenged by potentially higher default rates.

Real and alternative assets, as well as commodities, will also be crucial, in our view, for building inflation-resilient portfolios. Private equity, particularly in the US, tops our expected returns ranking while, on a risk-adjusted basis, global private debt is favoured. Hedge funds also may offer an appealing profile, having the lowest risk across the spectrum of real and alternative assets, and appealing returns. Real estate and infrastructure are vulnerable to the impact of climate-related events, but are appealing from a diversification standpoint, which may be key to targeting higher returns in an environment of higher risks.


A rocky net zero pathway calls for a new approach to portfolios

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Wealth managers are allocating more client capital to private assets. We look at the reasons so many are doing so, and specifically why they’re doing it now.

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**James Lowe**
Sales Director, Private Assets and Investment Trusts

Private client wealth managers have had robust arguments for allocating to private assets for some time. By 2021 four in five UK wealth managers had invested a portion of clients’ money in private assets.¹

These allocations are typically made in pursuit of enhanced performance and diversification, arguments that historic data continues to support. But other factors, such as the emergence of new vehicles for private asset investments, and the declining number of publicly-quoted companies, are also driving the trend.

Investors are also watching the investment landscape shift and assessing how resilient portfolios will be to a much altered environment. Of the major themes unfolding – like artificial intelligence and the renewable energy transition – many require private capital backing.

### How robust are the return and diversification arguments?

Past performance for numerous private asset classes compares favourably with liquid investment types, like traditional equities and bonds, over longer investment horizons.

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Crucially, private markets also have a history of performing differently to liquid markets.

Measuring how different investments move relative to one another – the correlation – is crucial to creating meaningful diversification. Again, data indicates that private assets can contribute to portfolio diversification.

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### What do the numbers mean?

A correlation of 1.0 (technically the “correlation coefficient”) means two assets move in exactly the same way. Smaller numbers indicate lower correlation.

James Ellison, Head of Private Assets Data Insights at Schroders Capital, explains:

“Private market investments offer a compelling means of diversifying a portfolio. The correlation between private asset classes and public markets is lower - as shown by the table. This allows them to provide diversification benefits by moving independently of the public markets.

“As well as behaving differently to public markets, they tend to behave differently to each other; well-balanced private asset portfolios can help mitigate risk. Additionally, the investment strategy itself can create further diversification, such as private equity investing in the lower mid-market.”

### New investment vehicles offer institutional-style private asset exposure for wealth managers and their clients

The above explains the familiar attractions of private assets for both advisers and their clients.

But what about the “why now”? What has changed?

Even for those with private market allocations, the overall share of portfolio remains low. The Investment Association found that private market investments comprised an average of 5% of UK wealth managers’ assets under management in 2021² . By comparison, our own research indicates that institutional investors had allocated 14% of their portfolio to private assets the same year³.

This discrepancy is in part because institutional investors have had access to a much broader range of solutions, structures and private asset managers. The options for individual investors, advised or otherwise, has been limited.

In the UK, individual investors have been able to use investment trusts for exposure and little else. However, ongoing growth and development in the private asset industry is changing things.

The long term asset fund (LTAF) has been spearheaded by UK regulator the Financial Conduct Authority (FCA) as a “new category of open-ended authorised fund designed to invest efficiently in long-term assets.”

The FCA created a new regulatory regime in 2021 to realise the LTAF structure.

LTAFs were initially designed to put pension capital to work supporting the UK’s long-term economic growth and the transition to a low carbon economy. New developments mean advised and discretionary investors will also be able to invest in LTAFs.

Widening the LTAF scope means more options in the UK authorised funds ecosystem, providing another access point to private markets for investors. We expect the LTAF to be a complementary tool to existing private asset structures – like investment trusts - offering new flexibility in how UK investors will be able to meet their objectives via private market investments.

### Public markets offer shrinking opportunity to access growth investments

While access has improved for private markets, options in public markets have continued to narrow.

The number of listed companies has been falling for years, and not just in the UK. The trend has been echoed in major markets around the world.

In 1996 there were over 2,700 companies on the main market of the London Stock Exchange. At the end of 2022 this had collapsed to 1,100, a 60% reduction. There has been a near-75% fall in the number of UK-listed companies since the 1960s.

Germany has shed more than 40% of its public companies since 2007 and the US has experienced a 40% drop since 1996.

One of the most striking effects of this decline is that the stock market now provides exposure to a dwindling proportion of the corporate universe. This is not just a UK issue: in the US, for example, fewer than 15% of companies with revenue over $100 million are listed on the stock market³ . Ordinary savers are largely deprived of the opportunity to invest directly in the rest.

Investors who focus solely on the stock market are missing out on a large and growing part of the global economy. Where they can, investors will need to explore private asset options to capture the growing private investable universe.

![chart03.png](/uploads/chart03_c47e0e1c71.png)

The decline is another powerful reason for investors’ increasing interest in private market allocations.

#### In the coming weeks, we will delve into more questions around LTAFs, how they will work, and how wealth managers might seek to incorporate them for private clients.

Sources:

[1] Source: The Investment Association, [Weaving private assets into wealth portfolios: Evolving structures to meet evolving needs](https://www.theia.org/sites/default/files/2021-12/IA_Goji_WhitePaper_PrivateAssetsinWealthPortfolios_Dec2021.pdf)

[2] Source: [Schroders, Schroders Institutional Investor Study 2022](https://mybrand.schroders.com/m/4eae38eb5825b0ed/original/SIIS22_Global-Private-Assets-Report_v11.pdf)

[3] Ibid


Private assets for wealth management clients: why, and why now?

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Author: Kate Lin, CAIA

Last week, we tested a strategy with two [Chinese equity indices](https://sg.morningstar.com/sg/news/211963/does-the-rhyming-%e2%80%9csell-in-may-go-away%e2%80%9d-work.aspx), and talked about how it timing the market makes you lose out on gains over the long-term. The modeling of index returns concluded that botching a market-timing decision does sacrifice a period of (strong) returns. It proved our point – time in the market is better than timing the market.

Tom Lauricella, Editorial Direct for Professional Audience at Morningstar, explains that [ineffective market-timing](https://www.morningstar.com/articles/972119/3-charts-that-show-why-investors-should-stay-the-course-throughout-market-turmoil) efforts can result in a significant opportunity cost and show the effects of missing the one best month on an annual return. “Although successful market-timing may improve portfolio performance, it is very difficult to time the market consistently,” says Lauricella, adding that the long-term gains from US stocks have been demonstrated to offset short-term losses.

Even worse, poor market timing means you give up the chance to gain more from the compounding of reinvested gains, therefore the net effect in an investment strategy is negative when compared to a portfolio that stays the course.

**What is Compounding?**

In a short answer, staying the course is the key to allow the compounding to work out. But what exactly drives compounding. Let’s start with what’s known as the ‘compound interest’ formula:

**End value = Initial value of capital*(1+Rate of change)Time**

1.  Initial Capital determines how much in absolute terms you can gain at a certain rate for a period of time.
2.  Rate of Change or the rate of investment return defines at what pace the initial and reinvested capital is to compound.
3.  Time Horizon defines for how many time periods your assets compound itself.

Put simply, compounding can be explained as the money (or returns) your portfolio earns each year, and then both your initial capital and your returns of previous years earn returns, leading to a point where you have a much larger capital pool. That means, the larger each of the equation’s components (on the right) is, the bigger your total capital would snowball into overtime.

It’s clearer in a side-by-side line graph that plots four scenarios. First, we let the base case (purple line) be a portfolio with a starting capital of $10,000. The portfolio invests in assets at the end of Year 0 that could generate an average of 10% each year and remains the same for the next 35 years.

For each of the remaining three lines, only one variable is adjusted in illustrating the outcome upon a shortened time horizon, a lower rate of return and a smaller capital to start in the equation.

![Elements in compounding.jfif](/uploads/Elements_in_compounding_c94ad1f49c.jfif)


With all else equal, beginning with capital in half means the portfolio will grow at the same rate but arriving at the exact 50% in the end value of the base case.

By contrast, when axing the investment horizon and the rate of return by half, what you afford is a return far less than just half of the base case. Shortening the investment horizon gives up the sessions that the portfolio can compound, while a smaller investment return simply flattens the curve by a large extent. Both result in merely 20% in end value as compared to the base case.

With a view to long-term performance, we go back to the base case of our data simulation and assume that in each calendar an investor adds 10% and 20%, in this case $1,000 and $2,000, to their portfolio (shown as dotted lines).

![Enlarging the compounding effect.jfif](/uploads/Enlarging_the_compounding_effect_64ba5c7108.jfif)


We find that upsizing the total portfolio value on a regular basis takes advantage of the compounding, enabling the portfolios to notch high absolute returns. This is for those who don’t have a large pot of starting investment capital, say at the early stage of their careers. Instead of sitting on cash to save up a sizable amount in some time, it is worth considering starting small to let the compound work. Expanding the capital base can come later by building up a disciplined top-up mechanism to your portfolio.

Indeed, the stock market is seen as a risky investment if you look at it for the short term. Data have shown proof that long-term returns have outsized short-term fluctuations and have triumphed over the risk of missing the one best month on an annual return by betting in and out. In practice, trying to call the trough and the peak of the market prices is distinctly tricky. The strategy involves a great deal of knowledge and luck. For individual investors who lack experience and time in technical research analysis, market timing would then be primarily driven by biases like loss aversion or herd mentality, which may cause some investors to end up buying high and selling low. Staying the course will bear fruit if you endure the time with discipline.

 

 

*©2021 Morningstar. All rights reserved. The information, data, analyses and opinions presented herein do not constitute investment advice; are provided as of the date written, solely for informational purposes; and subject to change at any time without notice. This content is not an offer to buy or sell any particular security and is not warranted to be correct, complete or accurate. Past performance is not a guarantee of future results. The Morningstar name and logo are registered marks of Morningstar, Inc. This article includes proprietary materials of Morningstar; reproduction, transcription or other use, by any means, in whole or in part, without prior, written consent of Morningstar is prohibited. This article is intended for general circulation, and does not take into account the specific investment objectives, financial situation or particular needs of any particular person. Investors should consult a financial adviser regarding the suitability of any investment product, taking into account their specific investment objectives, financial situation or particular needs, before making any investment decisions. Morningstar Investment Management Asia Limited is licensed and regulated by the Hong Kong Securities and Futures Commission to provide investment research and investment advisory services to professional investors only. Morningstar Investment Adviser Singapore Pte. Limited is licensed by the Monetary Authority of Singapore to provide financial advisory services in Singapore. Either Morningstar Investment Management Asia Limited or Morningstar Investment Adviser Singapore Pte. Limited will be the entity responsible for the creation and distribution of the research services described in this article.*

How Your Money Works for You

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Author: Carole Hodorowicz

It can be a challenge for investors just getting started to learn how to tackle debt, start saving, or find the best ways to pay off loans. Compounded by the coronavirus pandemic, addressing your financial situation can seem even more daunting when trying to learn the basics. 

We surveyed some of Morningstar's[ Generation Z and millennial employees ](https://www.morningstar.ca/ca/news/202904/generation-z-has-the-right-attitude.aspx)to hear their thoughts around money. Here are five lessons they learnt: 


**1. Paying Down Student Loans**

At the start of the pandemic, [the Government announced](lhttps://www.canada.ca/en/services/benefits/education/student-aid/notice-covid-19.html) measures to help students, including payment freezes.

There are pros and cons to continuing payments, and many good ways to make use of the money, like creating or building an emergency fund. If you contributed to your loans anyway, you reduced your principal. Paying down student loans is typically approached in one of two ways: [the snowball method and the avalanche method](https://www.morningstar.ca/ca/news/206124/how-to-paydown-debt.aspx). The snowball method prioritizes paying off the smallest loans first, while the avalanche method focuses on paying off the loan, no matter its size, with the highest interest rate first.

Here's how one employee took advantage of the grace period:

"As the pandemic happened and the government decided to set student loan interest rates to zero, I prioritized paying off as much as I could each month. I felt that I should try to pay the principal down since I will not have any interest eating away at my overall bill."


**2. Tackling Credit Card Debt**

With fewer ways to spend, some may turn their attention to paying down debt.

When approaching any kind of debt, you may be asking yourself the same question: Where do I even begin? Morningstar's director of personal finance Christine Benz recommends taking these steps first:

1) Buy yourself some time. Does your bank offer any options to extend a grace period or reduce your interest rate?

2) Make a list. How much do you owe, who do you owe, how much time you have, and what are the interest rates?

3) Pick a strategy. Do you want to go with the snowball method or the avalanche method

Here's a takeaway from one employee who focused on credit card debt:

"It's given me a new respect for that feeling of 'getting ahead' on payments. It's given me a chance to think more about my long-term savings goals--when I was so caught up in day-to-day spending, I didn't think as much about what I should be saving that money for instead." 


**3. Creating and Maintaining an [Emergency Fund](https://www.morningstar.ca/ca/news/206579/morningstar-money-challenge-day-7.aspx)**

The pandemic helped highlight the need to be financially prepared for the unexpected.

Our investment specialists recommend these tips to get a solid footing in the event of any unforeseen circumstances:

1) Tally up your monthly living expenses, from rent to groceries. Leave out the nonessential purchases.

2) Multiply these costs by three months. This is the minimum amount you should try to squirrel away.

3) See how much you currently have and set a savings goal.

During this time, many readjusted their focus to their emergency funds. Here's what one employee realized during this time:

"I believe that having a more holistic approach to budgeting is essential. Pre-pandemic, I was only focused on one aspect of my financial plan: paying off debt. Since the pandemic, I realized the importance of building up my emergency fund and having a backup plan in case of an unexpected occurrence." 


**4. Increasing Retirement Contributions**

The pandemic pushed some of our colleagues to look long term and consider how to stay on track for their retirement. Another effective use of the extra time and funds on your side is to focus on investing in your retirement plan. The earlier you invest, the more growth potential your retirement account will have.

Here's how one employee's priorities changed:

"After graduating from college during the pandemic, my biggest concern was finding a way to earn money. Now with a job, I am leaning into more savings, including a six-month emergency fund instead of a three-month and reaching my RRSP contribution limit."

It's never too early to plan for retirement.


**5. Cutting Back**

With office closures and stay-at-home mandates, several employees who responded to our survey said they are rethinking their spending habits during the pandemic. 

Here is how an employee embraced Morningstar's mission to think and invest with the long term in mind:

"I have been spending a lot less in areas that I would have normally spent on and putting more in savings. One thing I hope to do is work on finding a better balance between savings and investing and spending while not feeling like it restricts my lifestyle." 


5 Financial Lessons for New Investors

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Author: Valerio Baselli

Looking at the market today, it's easy to forget where we were at around 15 months ago. Many of the market declines of the past decade or so, including the stock market crash of 2008, are fast becoming faded memories for most of us. But it is the investors who endured these difficult times came out in perhaps the best shape, and as is often the case, those who had the nerve to stay invested were richly rewarded.

And yet, the decision about whether to change your investment strategy or sell a fund is usually not clear-cut, even in hindsight. After the dust has settled on a decision and the investment has performed well or poorly, the “right” answer is wholly dependent on the individual. Selling criteria are not a one-size-fits-all list that fit every investor, but there are some situations when selling is particularly ill-advised. Christine Benz, director of personal finance at Morningstar, picks these three key examples.

**Poor Short-Term Performance**
 
It’s almost never a good idea to sell a fund based on weak performance alone, especially over the short-term. You might have been tempted to sell in last year's market sell-off for example, but we now know the Covid crash was the shortest in history. Instead, if a fund is lagging its peers or an index, your first move should be to investigate why that is. It could be that the manager is simply sticking with an investment strategy that happens to be out of favour, as has been the case with many value-leaning funds in recent years. But weak performance may also be a sign that something more serious is afoot - Morningstar's own research has found that many active funds fail to beat the market over the long-term.

Researching an investment’s fundamentals can be time-consuming, which is why you don't want to get too caught up in investigating short-term bouts of underperformance. Most funds, especially those that are using truly active strategies, will trail their peers at times, often for very good reasons and sometimes for a few years or more (that could be the case with some perfectly solid, defensively positioned funds during a market rally, for example).

Instead, save your energy for checking up on funds when they've underperformed over longer stretches of time or in a period when you would have expected them to perform well. If, for example, you selected a fund because of its low-risk tendencies, but it lost far more than its peers in 2020, that's a legitimate reason to ask whether something about its strategy changed or its risk controls weren’t what you thought they were. And even if the fund isn’t bad, it may not be a good fit in your portfolio.

**Inconsistent Performance**

On a similar vein, investors often get themselves worked up when a fund’s relative returns are inconsistent on a year-to-year basis. Sure, it can be comforting to see a fund land in its category's top half like clockwork—and a small handful of funds has actually managed to generate return rankings that have been remarkably consistent from year to year.

But holding all of your funds to that standard would cause you to kick out some fine offerings that, while not consistent performers on a calendar-year basis, are consistent where it counts: they employ their strategies with discipline and don't waver, even if the market isn't rewarding them in the near term.

It's also important to remember that a calendar year is a fairly short and arbitrary time period, and a fund that has looked erratic over January-December time periods may appear perfectly consistent when measured over a different 12-month time frame—say, from April to March of each year. Investors shouldn't get too hung up on year-to-year performance consistency when deciding what to hold in their portfolios. Looking at annualised returns can be a better way to judge long-term performance, as these smooth out good and bad periods to indicate what average return an investor has received each year. 

**Macroeconomic News**

Macroeconomic news - whether it's the direction of interest rates, rising inflation or GDP growth in China and India - often appears right alongside news about the market's trajectory. And it's true that what's in the headlines has the potential to move the markets up or down on a daily basis, or even over longer time frames. The trouble is that by the time a certain news item makes its way into the headlines, other market participants have already digested it and priced it in.

If you decide to sell your fund based on that news, you're likely to be too late. Instead, a better tack for investors, at least as it relates to their portfolios, is to keep their heads down and focus on factors that they can control: their savings and spending rates, the quality of their investment holdings, and the total costs they pay for those investments. There is much virtue in tuning out the noise when it comes to managing your portfolio.





*©2021 Morningstar. All rights reserved. The information, data, analyses and opinions presented herein do not constitute investment advice; are provided as of the date written, solely for informational purposes; and subject to change at any time without notice. This content is not an offer to buy or sell any particular security and is not warranted to be correct, complete or accurate. Past performance is not a guarantee of future results. The Morningstar name and logo are registered marks of Morningstar, Inc. This article includes proprietary materials of Morningstar; reproduction, transcription or other use, by any means, in whole or in part, without prior, written consent of Morningstar is prohibited. This article is intended for general circulation, and does not take into account the specific investment objectives, financial situation or particular needs of any particular person. Investors should consult a financial adviser regarding the suitability of any investment product, taking into account their specific investment objectives, financial situation or particular needs, before making any investment decisions. Morningstar Investment Management Asia Limited is licensed and regulated by the Hong Kong Securities and Futures Commission to provide investment research and investment advisory services to professional investors only. Morningstar Investment Adviser Singapore Pte. Limited is licensed by the Monetary Authority of Singapore to provide financial advisory services in Singapore. Either Morningstar Investment Management Asia Limited or Morningstar Investment Adviser Singapore Pte. Limited will be the entity responsible for the creation and distribution of the research services described in this article.*

3 Bad Reasons to Sell a Fund

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No time  to yield

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###### By Georgi Mitov 

In this article we explore the complex hurdles that active portfolio managers encounter and how portfolio optimization is a crucial component of their daily routines.

Portfolio optimization stands as a core component within an active manager's strategic framework to consistently outperform benchmarks. This is a complex process aiming to balance risk, returns, and compliance with diverse constraints. These constraints cover a range of practical conditions, including sector delineations, asset allocation thresholds, and limits on position sizes. This process is truly multifaceted, grappling not only with a variety of restrictions, but also selecting between various objectives.

The objective could be to minimize risk, maximize return, or enhance risk-adjusted returns, typically using utility-based optimization or Information Ratio (IR) approach.

**Utility-based optimization**, rooted in the Markowitz framework, emphasizes risk-return trade-offs. This method employs a utility function, typically defined as the expected return of the portfolio minus a risk-aversion coefficient multiplied by variance. This can be mathematically expressed as:

![01-utility-ezgif.com-webp-to-jpg-converter.jpg](/uploads/01_utility_ezgif_com_webp_to_jpg_converter_a90c18449a.jpg)

Where E[Rp] is the expected return of the portfolio, Var[Rp] is the variance (or risk) of the portfolio returns, and λ is the coefficient of risk aversion (the higher the λ, the more risk averse the investor).

On the other hand, the **Information Ratio**, another measure of risk-adjusted return, focuses on maximizing the ratio of active return to tracking error. The Information Ratio (IR) is defined as follows:

![02-information-ratio-ezgif.com-webp-to-jpg-converter.jpg](/uploads/02_information_ratio_ezgif_com_webp_to_jpg_converter_fb2de3757f.jpg)

Where E[Rp - Rb] is the expected active return—that is, the difference between the portfolio return Rp—and the benchmark return Rb, σ(Rp - Rb) is the standard deviation of the active return, also known as tracking error.

One critical aspect of portfolio optimization involves limiting the number of assets in a portfolio. While it might seem counterintuitive to restrict potential investments, managing too many assets can dilute a portfolio's effectiveness.

This might lead to higher costs, reduced diversification benefits, and a deviation from the investment strategy. However, optimizing portfolios, especially for max IR, becomes more challenging when there are cardinality constraints. (e.g., constraints on the number of assets).

Many optimization tools lack support for solving maximum IR problems with cardinality constraints. As a workaround, active managers sometimes replace the IR with utility function defined as a difference between active return and tracking error.

![03-utility-ezgif.com-webp-to-jpg-converter.jpg](/uploads/03_utility_ezgif_com_webp_to_jpg_converter_5cbafb36b6.jpg)

While this simplifies the problem, it's a paradox—they seek to improve IR while optimizing based on another metric, which could affect their strategy, since those two optimization problems are not equivalent and those could result in different allocations as we shall see below.

To highlight the difference between Max Utility and Max IR optimization, we will define both optimizations within the FactSet Portfolio Optimizer (FPO). Following this, we'll conduct various analyses within the FactSet Programmatic Environment. For these analyses, we'll utilize the available FPO, Portfolio Analysis (PA) modules, and a comprehensive range of Python-based visualization tools.

Consider an optimization setup utilizing the Russell 1000 as a benchmark and an investment universe of identical stocks. We will introduce the following constraints, all of which aim to emulate the practical limitations encountered in portfolio management: sector and asset relative weights must fall within -3% to 3%, a maximum of 150 assets, a minimum of 20 assets, and a minimum weight threshold of 0.05%.

The alpha definition is derived from one of the Quant Factor Library analyst sentiment factors: QFL_PTGT_EST_REV(0,75D). That sentiment factor is based on Price Target Estimate Revisions with 75-day consensus window.

In Figure 1 below, we illustrate the solutions for Max IR optimization (represented as a blue point) and Max Utility optimization (represented as a red point), alongside the entire Efficient Frontier. The Efficient Frontier is the result of the Min Tracking Error optimization with a lower limit on the active return, considering all other weight and cardinality constraints as defined previously.

**Figure 1: Efficient Frontier**

![04-efficient-frontier-ezgif.com-webp-to-jpg-converter.jpg](/uploads/04_efficient_frontier_ezgif_com_webp_to_jpg_converter_2c5e94214d.jpg)

It can be observed that both solutions are situated on the Efficient Frontier as anticipated, however, they significantly differ from each other. For instance, the Max IR portfolio achieves an Information Ratio (IR) of 0.575, while the Max Utility portfolio only reaches an IR of 0.442.

Let's delve into deeper analysis of the two portfolios, examining sector and risk factor exposures.

As depicted in Figure 2, the sector exposure of both Max IR and Max Utility portfolios displays significant variations in their active sector weights. Max Utility seems to have a stronger preference for the Communication Services, has higher weightings in Real Estate, and is more underweight in Information Technology compared to the Max IR portfolio.

A marked difference is observed in the Materials sector, which is considerably more favored by Max IR. In consumer sectors, Max IR is more weighted to Consumer Staples, in contrast to Max Utility, which is more weighted to Consumer Discretionary.

In terms of Healthcare, Energy, and Industrials sectors, both portfolios are underweighted to varying degrees, with Max IR being more underweight in Energy and less so in Healthcare.

To wrap it up, distinct sector preferences between Max IR and Max Utility clearly highlight the differences between their individual investment strategies.

**Figure 2: Sector Exposure**
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Next, we compare the risk factor exposures of the two portfolios (Figure 3). The Max IR and Max Utility portfolios both show different exposures to various factors in comparison to the benchmark.

Looking at the two portfolios, Max IR and Max Utility, we see some key differences in their investment approaches across several risk factors such as Dividend Yield, Momentum, Liquidity, Size, and Volatility.

Specifically, Max IR tends to place less emphasis on Dividend Yield, indicating a less conservative focus on immediate income generation from dividends. It has a stronger preference for Momentum, showing it favors stocks with more upward price trends. In terms of Liquidity, Max IR leans into investments with more Liquidity.

On the other hand, Max Utility shows a different picture. It has a more noticeable tilt towards larger companies. However, it has a slightly negative exposure to Liquidity.

Both portfolios, along with their benchmark, showcase an aversion to volatility. That reflects a more conservative stance toward market uncertainties.

**Figure 3: Risk Factor Exposure**
![06-ending-portfolio-exposure-ezgif.com-webp-to-jpg-converter.jpg](/uploads/06_ending_portfolio_exposure_ezgif_com_webp_to_jpg_converter_e8173aea02.jpg)


Again, we conclude that in relation to their exposure to risk factors, the two portfolios display significant differences. That reaffirms our thesis: These are two different optimization problems that, in most instances, lead to significantly different optimal portfolios—despite their objectives seeming similar in terms that both risk and return coefficients in both cases are one.

In conclusion, choosing the appropriate objective function is of utmost importance in portfolio optimization. Access to sophisticated solutions that offer such functionality is invaluable for active managers navigating the intricacies of investment decisions in today's dynamic financial landscape.



Why Choosing the Right Objective Function Matters: How to Achieve Maximum Information Ratio With Portfolio Optimization

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