Gordon Hagart is a journeyman in both senses of the word: a professional, fully educated in his trade and preparing his masterwork; but also a traveller. His path has taken him from his native Scotland by way of London, Geneva and Zurich to Melbourne to work as Head of ESG Risk Management at the AUS$85.17bn (as of March 2013) Future Fund in Australia. Hagart’s career started in investment banking with Greenhill & Co. in London. He switched routes to combine a personal passion for sustainability/finance and a non-financial educational background (Bachelor’s and Master’s degrees in geophysics) by becoming Programme Manager with the United Nations Environment Programme in Geneva. There, he was involved in the genesis of the UN-supported Principles for Responsible Investment (PRI). A subsequent post as Senior Consultant with onValues in Zurich involved him in advisory work for initiatives such as the Enhanced Analytics Initiative. The ESG role at the Future Fund is a grand synthesis of this dual financial/sustainability career to date. The fund is in the big league of sovereign wealth investors and in addition runs the $4.07bn Education Investment Fund, the $5.02bn Building Australia Fund, and the $3.19bn Health and Hospitals Fund assets. Established by the country’s Future Fund Act 2006, its role is to assist future Australian governments meet the long-term cost of public sector superannuation liabilities. Its initial treasury came from a mix of budget surplus, assets from the privatisation of Telstra, the Australian state telecoms company, and the sale and lease-back of government real estate. No money will be added to the fund other than investment yield. The fund’s mandate is to return Australian inflation plus 4.5-5.5% per annum, with strategic responsibility lying with the Future Fund Board of Guardians, supported by the Future Fund Management Agency, its investment unit, which allocates capital toabout 100 external fund managers. Indeed, the fund looks more like an endowment than a pension fund, with its large allocation to real assets and unlisted, illiquid investments. Highly diversified across asset classes, Hagart says it seeks exposure to as many interesting risk premia as possible. This is due to its long horizon: the current Future Fund legislation runs until at least 2020 when initial funds may be drawn down. Hagart’s ESG risk role was a newly created position in October 2009. Four years in, he talks RI through the fundamentals that underpin the fund’s adoption of a responsible investment strategy, starting with its view that current short-term market economics can require intervention from long-term institutions: “There’s an understanding here that investors like pension funds, insurers and sovereign wealth funds are sometimes not particularly well served by modern markets. And there’s a bunch of ways we can try to readdress that problem. One of them is to think about ESG risks.” He notes that being short-term in any investment sense is a disservice to its client, the Australian government, and its long-term liability horizon: “There are issues that it is hard for the market to get its head round because of myopia. Our board believes that if we don’t think about these long-term issues then we’ll either take too much risk or miss out on opportunities as a fund. We can tackle some of these issues by using ESG as an analytical tool, either by in-house, top down strategy research or via our asset manager agents.” Getting more specific, he says the fund talks about ESG issues, management risk and ownership rights in one breath. The first stage of ‘governance’, he says, is the relationship the fund has as an asset owner with its service provider investment managers to address any potential “misalignments” of interest.
Second is what he calls the more profound “integrated ESG analysis” conversation with fund managers: “The calling card of fundamental asset managers is that they
can add value by understanding the drivers of risk and return in a given company better than the market, and we believe ESG information is key to that value premise over the time-frame of our investment contracts with those managers. Our opening gambit in that discussion is that we want them to take into account everything that is financially material and nothing that is not! We’ll often go through case studies, such as water scarcity in the extractives industry.” He points out, however, that the ESG conversation differs significantly from passive to quant to fundamental, commodities or real estate investment strategies. For example, Hagart notes that passive managers, have ownership rights if they run an index-based portfolio. How they execute those ownership rights, he says, is as important to the fund as price and client servicing.
He adds: “Ultimately what links the discussions across all asset classes is fundamental fair value. For example, if we are talking about an equity or bond investment in a South African platinum producer then labour issues can be really important to that company and can seriously hold up production in the event of a problem. So we would have a conversation with the manager about that issue.” He points out that at this point there can be a danger of self-censorship in ESG discussions if a mainstream fund manager comes along and says: “OK, well that’s just an investment issue, leave it to us.” This, he says, is because of the nature of the asset owner/manager contract and the valuation process for assets. “In private markets, our thinking starts with the premise that we’re going to be holding onto an asset for 6 or 7 years, and perhaps substantially longer than that in some cases. Next is that the individual buy and sell decisions of the manager are both hugely important to us. If we’re holding assets for 6-10 years, the value we realise at the end of those holdings is based on expectations of future cash flows discounted back to the end of our holding. So we always have to belong-term because the sale value is based on a much longer-term horizon than our ownership period. We have to have a meeting of minds with our managers on that.”
The financial value of asset ownership rights and their exercise via voting and engagement, Hagart says, is another strong fund belief: “We have a duty to be prudent stewards of the ownership rights as much as the underlying asset that generates the right.” Again, the fund has carefully considered its rationale: “The way the market is structured requires us to use agents along the investment chain, and of course we too are agents. But these agents are often imperfectly aligned with the ultimate owner’s interest. Corporate governance is one of the tools you have to reduce those misalignments and put in checks and balances. We also believe it is a critical way of ensuring a human “interface” between owner and company, in what is, after all, the very human business of running companies well!” He rebuts the critique of some investors that corporate governance suffers from lack of potency (atomised shareholdings) or the free-rider effect where other investors don’t contribute to the cost of governance efforts, but benefit if there is a market premium. “We don’t think it’s helpful to think of isolated issues, but rather of the market effect. It’s the counterfactual that motivates us: what would happen if everyone assumed that someone else was policing corporate governance and that they could just hitch a free ride? Then you’d really begin to see the true magnitude of agency and intermediation costs…. and we’ve seen a few of those in the financial crisis alone. Do unto the market as you would have the market do unto you! Besides, we’re trying to make absolute, real returns for our client, so free riders should be neither here nor there. If a corporate governance intervention adds return to or reduces risk in our portfolio net of costs, it’s a good thing. If someone else happens to get a free ride on that, well, good on them.”
Fund manager voting and engagement capabilities
are a key factor in manager hire assessments: “We feel this is another way that managers can add value.” Hagart acknowledges that the fund can’t scrutinise all corporate governance decisions taken by its managers. However, he says it does have complete visibility on manager voting because of its segregated account approach. The exception is Australian listed equities where Hagart is personally responsible for corporate governance, but keen to tap the corporate knowledge of its asset managers: “Take, for example, a company like BHP Billiton, we own a large aggregated position based on the investments of 4-5 fund managers, and we don’t want to eschew the investment knowledge coming out of those managers but rather harness it. We’ll regularly get their input into our voting process, and on engagements the managers themselves might be best placed to approach the company.” He explains how the fund decides where and when to focus its engagement energy and budget: “The triage is a Venn diagram, which includes how many dollars we have invested (the value at risk), the percentage of the company’s stock we hold (our capacity to influence) and the nature of the ESG issue (housekeeping versus an existential threat). In reality, it’s a relatively small number of companies I focus on internally.” Importantly, Hagart says Australia has a good climate for corporate engagement where corporates and investors see the value of working together: “There is also a lot of collaboration between Australian asset owners and the Australian Council of Superannuation Investors. We’re 95% aligned with other Aussie asset owners on these issues.” Despite the ESG engagement work, the topic of corporate exclusions is invariably where investors like the Future Fund make the headlines. In February this year, the fund sold out of shares in 14 tobacco producers to a value of $222m, or 0.3% of total fund assets. David Gonski, Chair of the Future Fund, said the decision followed a review of the investments by the Board’s Governance Committee, which looked at tobacco’s damaging health effects, addictive properties and the fact there’s no safe level of consumption. Hagart explains that all exclusion decisions are made in house, but notes that the fund doesn’t consider blacklisting companies to be part of its ESG work: “There are common issues that are the root of our ESG strategy: above all making more money with less risk, or ESG as areputational management tool, or even what could be termed the ‘hassle factor”, i.e. how much time could a controversial investment decision take up when you could get the return elsewhere? But in terms of exclusions the main motivation is the fact that our money belongs to the Commonwealth of Australia. There are certain economic activities that we could invest in that would be entirely legal, but where we feel that it would be incongruous for the Commonwealth to be a provider of capital. Activities that conflict with international conventions ratified by Australia are the obvious example here. But we’d be the first to admit that this can be a very tricky space. That’s why we have in place a policy framework and a governance process for reviewing issues that can often be complex and somewhat opaque.” The fund generally bases its policy on international conventions. Australia is a signatory of the Anti-Personnel Mine Ban Convention, and the Convention on Cluster Munitions. To this end, the fund has excluded ten companies whose economic activities contravene either convention. This year’s tobacco decision, says Hagart, was a special case, given tobacco’s legality. The Australian government banned cigarette company logos on packets in 2012. But, Hagart says, the Future Fund operates independently of government and the decision was taken 100% by its board. Surprisingly perhaps given Hagart’s involvement in its creation, the Future Fund is not a signatory of the UN-supported Principles for Responsible Investment. He explains why not: “Part of the reason is that we are a young fund and we think you need to bed down your investment beliefs, build your internal governance and resources, and then be more active. The board’s main SIP (Statement of Investment Principles) makes some pretty clear statements on the value of looking at ESG issues and managing ownership rights actively. This is underpinned by a number of internal policies and processes relating to ESG issues. But we are still on a journey of building out strategies and resources in this space. I’m biased, of course, but we have the greatest respect for what the PRI has achieved, and clearly we have been a beneficiary of its efforts. We have really good relationships with the initiative and its signatories. It’s a discussion our board will come back to.”