Investment surgery
What are the key arguments for SRI over “mainstream” investing?
The ESG factors that sustainable and responsible investment (SRI) analysts and fund managers specialise in are increasingly material to the value of companies. As a consequence, SRI strategies are being adopted by trustees seeking to deliver on their ESG fiduciary responsibility and in maximising investment returns. There are four main SRI strategies: integration, engagement, positive screening and negative screening. These can be deployed independently as alternatives or combined to develop increasingly sophisticated SRI strategies. However, some contradictions can emerge when combining strategies. The key is in understanding these implications and selecting the approach that best fits the scheme’s investment strategy. Looking at ESG issues has been criticised as being a distraction from achieving superior financial returns. This argument assumes that these issues do not materially affect the value of companies. However, not systematically including these issues in the investment decision is not prudent as they can fundamentally affect the value of companies now and in the future.
How do ESG (or SRI) funds perform relative to “mainstream” funds?
Consultant Mercer, in conducting a study with UNEP, concluded that the research didn’t support the view that SRI funds underperform conventional funds. Equally, the jury is still out on whether there is a market inefficiency that enables SRI funds to outperform conventional funds over the long term. We believe that ESG issues are frequently material to long-term performance and that there is a market inefficiency that investors can exploit for financial gain. In our view, with an increasing number of analysts seeking to exploit this inefficiency, ESG analysis will continue to grow in relevance.
Do not assume ESG issues are being incorporated by all fund managers. Ask your fund manager how they do this, and what the main risks and opportunities are in your portfolio. Be wary of fund managers who do not appear to have any interest, or expertise to draw on in incorporating these issues or are unable to back up claims they make in this area.
Do trustees have a responsibility to take ESG considerations into account in their investment decision making?
The latest financial crisis and subsequent events have highlighted the role that should be, but is often not, played by responsible investment strategies. The costs to pension schemes and others of the unsustainable risk taking, misaligned incentives, moral hazard and other issues, as well as the problem of 'absentee landlords', that characterised the financial crisis, should be clear to all involved in the pensions and investment industry.
Whilst trustee investment decision-making is principally governed by trust law, legislation, regulation and best practice guidelines, it was the misrepresentation of the judgement in Cowan v Scargill (1984) that gave rise to the misconception that trustees’ only and overriding investment objective is profit maximisation. Indeed, the ruling in Harries v Church Commissioners (1991) firmly supported the explicit incorporation of ESG factors into investment strategy.
The most effective document for promoting the integration of ESG issues into investment is arguably the ”Freshfields Report”*, published in 2005. This report was asked to consider: “Should integration of environmental, social and governance issues into investment policy be voluntarily permitted, legally required of hampered by law and regulation?” Freshfields concluded that “…integrating environmental social and corporate governance considerations into an investment analysis so as to more reliably predict financial performance is clearly permissible and is arguably required in all jurisdictions”.
This clarified the legality behind whether pension schemes could consider ESG issues. In 2009, the United Nations Environment Programme’s (UNEP) Fund Management Working Group followed up this report. Among their suggestions was that advisors to institutional investors, such as trustees, have a duty to proactively raise ESG issues within the advice they provide and that a responsible investment option should be the default position. The report also proposes that investment consultant and fund manager clients should be able to sue for negligence if these issues are not properly considered.
* (Freshfields Bruckhaus Deringer, “A Legal Framework for the Integration of Environmental, Social and Governance Issues into Institutional Investment". UNEP Finance Initiative Asset Management Working Group, 2005.)
How can trustees integrate ESG issues into their investment decision-making?
This, of course, raises the question of how trustees should go about delivering on any ESG fiduciary responsibility. After all, trustees do not routinely get involved in company meetings, stock picking or portfolio construction – often delegating this to their fund managers. Well, schemes can include ESG clauses in Investment Management Agreements (IMAs) and require fund managers to periodically report on their ESG performance. For instance, being a member of the United Nations Principles for Responsible Investment (UN PRI) requires that “where consistent with fiduciary responsibilities” signatories should commit to integrating ESG issues into investment analysis, to being active, responsible owners by promoting good corporate practice in these areas and to reporting on what actions they have taken.
The UN PRI monitors delivery of these principles via a questionnaire, which benchmarks signatories performance in relation to each principle. As trustees have a fiduciary duty in this area, they should require their fund managers to make this information available to them at no additional cost.
For further information on the UN PRI see www.unpri.org/principles
How should a trustee go about delivering on their ESG fiduciary duty?
The most obvious steps are for schemes to include ESG clauses in Investment Management Agreements (IMAs), and to require fund managers to periodically report on their performance. For instance, being a member of the United Nations Principles for Responsible Investment (UN PRI)** requires that “where consistent with fiduciary responsibilities” signatories should commit to integrating ESG issues into investment analysis; to being active, responsible owners by promoting good corporate practice in these areas; and to reporting on what actions they have taken.
By choosing to embed UN PRI membership into the global investment management agreements that we asset managers propose to our clients will help clients hold their managers to account for delivering on this important aspect of fund management.
What is the United Nations Principles on Responsible Investment (UN PRI)?
Critically, the UN PRI monitors the performance of its signatories in delivering their responsible investment principles via a relatively detailed questionnaire. This involves an annual assessment that benchmarks each signatory’s performance in relation to each principle. This analysis is then shared with signatories, most of whom unfortunately do not share it with the very people whose money they are managing.
While reporting on performance to the UN PRI is one principle of the UN PRI, signatories are not required to share these performance assessments with clients. This is a missed opportunity and is quite wrong in principle. As Trustees have a fiduciary duty in this area, their agents should be required to make this information available to them at no additional cost. Ultimately, this will lead to more informed market demand for responsible investment. How else can Trustees be expected to hold managers to account and appropriately govern the execution of this duty?
* (Freshfields Bruckhaus Deringer, “A Legal Framework for the Integration of Environmental, Social and Governance Issues into Institutional Investment". UNEP Finance Initiative Asset Management Working Group, 2005.)
** For further information on the UN PRI see
http://www.unpri.org/principles.
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