It is no secret that sustainability is a key consideration for any investment portfolio. But like with anything, sustainability risks and opportunities have a financial and economic impact on the assets of a family office. However, sustainable investment can be confusing for investors. It can be difficult to know where to start and what should be a priority. Technology platforms that enable the quantification, assessment, and adjustment of sustainability risk in a portfolio offer a chance to improve outcomes and potentially enhance returns.

Understanding the magnitude and nature of your exposure to sustainability risks is the first step in setting a plan to manage, mitigate, and monitor that risk. Leveraging sustainability factors to improve your portfolio's risk-adjusted return is a three-step process:

1. Insight
Investors need a tool that can assess where their risk exposures currently lie, enabling them to determine where they want to go, and what portfolio changes need to be made.
2. Intervention
Investors need tailored actions and a plan focused on improving ESG exposures. Incremental improvements are critical to success in the long term.
3. Impact
The ability to monitor the impact of actions over time is critical. Every improvement gets the investor one step closer to meeting their goals.

Step 1: Insight
One of the biggest challenges facing family office investors when making sustainable investments is a lack of understanding of the sustainability factors present in the current portfolio. Most family offices are looking to drive sustainability through their investment practices, and an increasing number of family offices say that they are making progress in incorporating sustainability in investment decision-making. Family offices face unique challenges in quantifying sustainability risk because they combine investments (e.g. direct vs. indirect, private vs. public, etc.). Technology is vital to modeling the current state so that the family office can put an action plan together.

Focusing on climate risk, scenario modeling can provide the basis for making portfolios robust to endure future challenges while exploring emerging opportunities. Scenario analysis can be used to assess the impact of global temperature increases on various industries and companies, offering unique insights into the possible future states of the portfolio. Next, the investor can take corrective action to minimize risk across these scenarios, helping to improve climate metrics for transition, as well as physical damage risks.

Quantitative modeling and analysis can combine economic and scientific practices. The granular analysis allows investors to consider whether climate impacts are fully priced into every asset class and economic sector before making reallocation decisions. This helps to promote sustainability integration with the internal investment team.

Databases and rating systems are also critical for comparing sustainability factors across investment managers. Without access to such a database, it is difficult to know if third-party managers are offering best-in-class exposure to sustainability factors while mitigating risk.

Step 2: Intervention
Family offices are uniquely positioned to intervene as part of their sustainability strategy due to their increased use of direct investments. However, there is more to investing sustainably than just divesting or excluding certain assets from a portfolio. For example, through engagement, investors can help companies create a range of measures to improve their longterm performance. Additionally, by understanding how the world is changing, both in an economic and environmental sense, investors can position their portfolios to target sustainable opportunities that may emerge.

Leveraging the analysis done in the 'Insight' step enables family offices to take action and then reassess the impact of changes that they have made over time. However, it is not enough to just understand the current position. Through stress testing and scenario analysis that incorporates ESG factors, investors can develop an optimal portfolio that maximizes expected risk-adjusted returns after accounting for sustainability risks and opportunities.

Not only can this be done at the investment level, but for direct investments, this can also be done at the policy level. For example, engagement that leads to changes in organizational policy can have a material impact on sustainability risks for a direct investment, and consequently, the impact of this engagement can be quantified from a risk/return perspective.

Traditional optimization analysis can also be conducted on inclusionary and/or exclusionary policies within a portfolio. This can be done at the industry level or the firm level. In either case, it is vital to refresh data as often as possible to ensure that returns, risks, and correlations are accounted for as financial and environmental realities shift.

Step 3: Impact
Assessing and reporting on impact is also critical to ensuring that corrective action can be taken if investors’ action plans do not take them to their objectives. Even the best-laid plans cannot account for shifts in capital markets and society, and it is critical to have models that are flexible enough to be updated while being robust enough to account for new data points and risks. This emphasizes the importance of both scenario analysis, stress testing, and sensitivity analysis when quantifying sustainability risk in portfolios.

Sustainability is not limited to environmental factors and also includes diversity, inclusion, and social factors that can be more challenging to quantify. For example, technological advancements across various sectors will shift where job opportunities exist in the economy. Being able to assess the patterns is vital to minimizing downside risk in portfolios, particularly in portfolios where concentration risk is high. It is critical to cast a wide net when evaluating how societal change could impact your portfolio.

Managing sustainability risks inherently requires investors to look years, and often decades, into the future. While there is no guarantee of what the future will look like, technological advancements have given us the ability to review and analyze sustainability data unlike ever before. To maximize risk-adjusted returns, thorough reviews of sustainability risk and opportunities must take place. Family offices are uniquely positioned to not only conduct this analysis but to leverage the results to intervene and improve investment performance.

This article is from The Wealth Mosaic’s GFO WealthTech Landscape Report 2022. Access the full report here.