2022 Perspectives for the Public Sector

Citi Perspectives for the Public Sector 5 Winnie Zhang Public Sector, Citi Sophia Oh Public Sector, Citi Integrating ESG into Existing Portfolio Construction Frameworks D ifferent approaches to portfolio construction have evolved over time. But whether their primary focus is on asset classes, risk factors, or the separate pursuit of alpha and beta, what they all have in common is that they are all still being used today. One of the key challenges for asset owners is how to think about the pursuit of environmental, social and governance (ESG) outcomes within the framework of their existing portfolio construction methodology. This article provides some perspectives, and practical approaches, on how to address that problem. A brief history of portfolio construction Modern portfolio theory, defined in the capital asset pricing model, emerged in the late 1950s. For about five decades, it was the predominant approach to portfolio construction. The capital asset pricing model highlights the trade-off between risk and return, and the consequent importance of diversifying exposure across asset classes – the model gave rise to the concept of risk-adjusted return. The theory led to the widespread adoption of the 60/40 rule. Known colloquially as ‘set and forget’, a portfolio with a 60% allocation to equities and 40% to bonds was used as a template by most institutional investors until the late 1990s. Indeed, some major institutions continue to use it today. However, around the turn-of-the-century, the Fama-French factor model began to gain ground. It showed how specific variables, such as size, growth characteristics of a company, credit rating or duration of a bond underpinned market returns – or beta – and that certain factors outperformed others at certain times. In other words, an asset class came to be seen as just a wrapper for a selection of risk factors. Michael Paulus Head of Public Sector APAC, Citi Robert Crossley EMEA & APAC Head of Business Advisory Services, Citi Markets Financial Institutional Sales and Solutions, Citi