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Commentary

The Benefits of Increased Portfolio Customization

CEO and portfolio manager Patrick O'Shaughnessy talks ESG, custom indexing, and factor investing.

The CEO and portfolio manager of O'Shaughnessy Asset Management and author of Millennial Money: How Young Investors Can Build a Fortune, Patrick O'Shaughnessy outlined multiple options for portfolio customization and discussed their potential benefits on Morningstar's The Long View podcast.

Highly customized investment portfolios are becoming more appealing to a broader audience. Examining this development, O'Shaughnessy unpacked some of the advantages of tailoring portfolios through environmental, social, and governance integration, custom indexing, and factor investing. He also shared his thoughts on the growing trends of mass customization and technology-driven investing.

Here are a few excerpts on ESG investing from O'Shaughnessy's conversation with Morningstar's Christine Benz and Jeff Ptak:

How to Assess ESG Trade-Offs

Ptak: Let's start with ESG, a topic your team has written a lot about. Your firm thinks the best approach to ESG is customization, contouring the portfolio around a client's personal preferences. How do you help clients weigh the trade-offs associated with those preferences?

O'Shaughnessy: Well, we try to be very up front about what choices in an investment strategy mean for each investor. And in the case of ESG, I think the cleanest way to describe that is what we would call tracking error--or, how much are you putting into your strategy that's going to make your returns different than, say, the S&P 500. And we don't know whether that tracking error is going to be good or bad. It just means different than the underlying benchmark. And we think of that as a nice measurement of what I'll call cost. So, if you care deeply about not owning a certain type of company or owning a lot more of a different type of company that has a feature that you want to support, again, we don't know if there will be alpha in that decision or not. It's very hard to say, like anything. But we can give a good clean estimate of, we think in a normal market, this will cause you to perform X percent plus or minus the benchmark. And we find that framing to be the responsible way to think about it. It equips the investor with the framework to really understand the trade-offs associated with their choices. And what we've seen is that that tracking error as this measure is a great way for advisors and for clients to guide their ESG decision-making.

Articulating ESG Preferences

Benz: How well equipped are advisors and individual investors to express their ESG preferences? For example, do you think they know what terms like "water stress" or "carbon intensity" really mean, let alone the investing implications of managing for such preferences?

O'Shaughnessy: Well, I think this is a classic case of the average not being the right statistic here. There are definitely distinct cohorts of types of investors. Lots probably would not know what "water stress" means. And the group that doesn't know is also not adjusting for it. What we've seen is that there is a very strong and vocal sort of minority that cares deeply about these ESG issues in their portfolios. And for many of them it is the single most important thing in their portfolios. We think it's 15% or 20% of investors today, which is roughly the percentage of Canvas [O'Shaughnessy Asset Management's investing software] users that adjust for ESG when given the option to do so. But that means 80% don't. That number is rising, to be clear. But I think it's really two distinct groups with lots of subgroups: Those that don't know what water stress means or what a lot of these things mean and haven't really thought about it, and those that know deeply what these things mean. In many cases, advisors build their whole practice around a certain type of ESG profile portfolio that we help fulfill. And then, of course, the advisor knows deeply, and they are attracting clients who have similar interests, values, and desires to impute those values into their portfolio.

This article was adapted from an interview that aired on Morningstar's The Long View podcast. Listen to the full episode.