In 1987, Polish-born Piotr Chmielowski left his communist homeland to study theoretical physics in the US. Now, as chief risk officer of Fulcrum Asset Management, he is taking another leap into the unknown—attempting to quantify risks many think unquantifiable. 

The risks are environmental, social, and governance, or ESG, risks—which the $4.9 billion asset manager defines as something that can influence its future returns, rather than as a measure of how ethical the investment is. 

The firm is engaged in “very quantifiably” integrating ESG risks into its investment and risk management processes across all funds, says Chmielowski, which includes those that invest in government bonds, currencies, and alternative assets—tough to measure in ESG terms.

“Once this is finished—in the next two months, I would think—our systematic funds and our discretionary funds will all have the ESG component as part of the risk assessment. They already include it to an extent… but they will do it in a purely quantifiable, numerical way,” he says.

Ideally, the process should involve three steps, he explains. First, each potential investment should be assigned an ESG risk score and an expected return. Then, the firm should set a risk tolerance for ESG risk—and this may differ between funds. Lastly, these numbers, along with values for non-ESG risks, should be run through a portfolio optimization engine. The resulting portfolio should provide the maximum return for an acceptable level of overall risk. 

There may be slight differences in the way the process is applied to different investment strategies, says Chmielowski. “For some funds, we may have more stress on climate, and for some funds we may have more stress on social and governance issues,” he says.

“But the high-level approach is, you penalize investments based on the ESG risk,” he adds. “It is a risk. So we need to incorporate it in our portfolio construction and risk management the same way we incorporate currency risk, volatility risk, credit risk, and so on.”

To produce ESG risk scores, Fulcrum will use external ratings and its own analysis.

Chmielowski and responsible investment officer Iselin Aslakstrøm acknowledge there are problems with the relatively young practices of ESG data disclosure and scoring. Much of the data is patchy, covers too short a period, and is plagued by bias. 

But Chmielowski suggests Fulcrum will not let the perfect be the enemy of the good.

“Given the importance of ESG considerations that society as a whole seems to be attaching to the subject, we need to make the best use of what is available, but also be conscious of the limitations—and not assume blindly that the best measure available now will be the best measure forever,” he says.  

New measures

Whatever the limitations, there are plenty of vendor ratings for equities and corporate bonds—the traditional domain of ESG investing. But few such ratings exist for government bonds, currencies, and alternative assets, which make up a large share of Fulcrum’s investments.

Chmielowski says one way to get around this is to use available vendor data—on a country’s political freedoms, for example—to rate the ESG risk of its government bonds. 

This step can then help work out the ESG risk of the country’s currency and interest rate swaps, as all three are linked—though it is not a straightforward exercise. “There are usually too many moving parts to be sure over a short time horizon. [But] over many years, this should average out to a clear relationship,” Chmielowski says. 

For Chmielowski and Aslakstrøm, one measure that inspires confidence is a gauge they developed with a data vendor for the Fulcrum Climate Change Fund, which launched in August. The fund maintains a weighted-average portfolio temperature of below 2° Celsius for companies in the portfolio. No company will have a higher temperature than 2.5° Celsius. 

This means the fund invests only in those companies whose current and planned activities will not contribute to an excessive rise in global temperature this century—defined as at least 2° Celsius above pre-industrial levels, Aslakstrøm explains.

“The decarbonization efforts of a company are compared with the required decarbonization trajectory of its sector. The output is an ‘implied temperature rise’ metric, indicating the level of alignment with the global warming target limits,” she says.  

In principle, the same methodology could be applied to countries, Aslakstrøm adds, but she cautions that countries’ economic activities are much more complex than those of most companies.

If ESG data lacks history, the concept of ESG risk tolerance is even more novel. Chmielowski says the ideal would be to quantify a unit of ESG risk and compare it with the unit of investment return, but the thinking on this at Fulcrum—and in the industry as a whole—is still evolving.

Although ESG risk tolerance will probably vary between different funds at Fulcrum, between individual investments in the same fund, it will not. At least, this is the latest thinking at the firm. “This will hopefully average out the inherent uncertainty of risk assessment for individual investments,” Chmielowski says.  

Given the importance of ESG considerations that society as a whole seems to be attaching to the subject, we need to make the best use of what is available, but also be conscious of the limitations

Piotr Chmielowski

Fulcrum’s fund-level ESG risk tolerance may in the future partly depend on whether the fund is domiciled in the European Union or the US, he notes, as regulators on different sides of the Atlantic have given divergent guidance on ESG risks. 

For example, regulation proposed by the European Commission requires firms that provide investment advice and portfolio management to integrate sustainability risks into risk management policies. They must also consider clients’ sustainability preferences, in addition to their financial objectives. 

The US Securities and Exchange Commission, on the other hand, is just in the process of formulating its views on these issues. But the US Department of Labor has already set out its stall. In June, it proposed a rule clarifying that private pension plans “are not vehicles for furthering social goals or policy objectives that are not in the financial interest of the plan”. Its proposal did acknowledge, however, that an investment’s ESG characteristics can present material economic risks or opportunities.

The weight of opprobrium

Just as its ESG risk tolerance may differ between portfolios, the design of Fulcrum’s ESG risk scores may vary too. “For some funds, this score may put heavier weight on E, while for others it could be more equally weighted E, S and G. For example, for the Fulcrum Climate Change Fund, the E aspect is—as the name says—the fundamental part of the fund design,” Chmielowski says.

The £70 million ($89.2 million) fund is Fulcrum’s first foray into impact investing. In addition to financial return—adjusted for risks, ESG or otherwise—the fund is intended to benefit society.

“If, hypothetically, all investors in the world invested in our fund only, then in theory all the equities that are warmer than the parameters of the fund would go to zero because nobody would want them. So, with certain qualifications, it’s a direct impact fund that aims to make global warming less of a threat,” Chmielowski says.

Fulcrum believes it will be able to align the fund with the decarbonization targets of the Paris Agreement without sacrificing returns, adds Aslakstrøm, as in the firm’s view, this transition is not yet priced in.

The climate change fund expands on an existing direction at Fulcrum that it calls sustainable investing. A March policy document on its website says it means “investing with sustainability front of mind by looking for relevant trends to invest in or making the sustainable choice when possible”. It also mentions some of the firm’s strategies that follow this approach. 

My guess is that in 10 years’ time every investor will be an ESG investor

Piotr Chmielowski

Further, Fulcrum does not invest directly into companies that are involved in controversial weapons, predatory lending, or companies that generate a pre-defined part of their revenue from tobacco-related activities.

The ESG risk-integration project stands apart as it is not about making ethical choices. “We view ESG risk integration just as another type of material risk,” Chmielowski says.

When it comes to Fulcrum’s focus, however, it is clearly paying more attention both to ESG risks and choices—and that may put it in good stead for the future.

“My guess is that in 10 years’ time every investor will be an ESG investor,” Chmielowski says. “Investors will have their own ESG considerations and will look for investments that are aligned to these and the associated risks.”

But, he adds: “I don’t think that every investor in 10 years’ time will be an impact investor.”

Additional reporting by Noah Zuss