Some investors approach this subject from a definitively ethical perspective; others view it predominantly from a risk management standpoint. Some place far more emphasis on specific themes within the ESG spectrum, such as climate change, corporate activism or social impact, than their peers. For instance, “de-carbonisation of equity portfolios” has become increasingly popular in Europe with major investors such as FRR taking the lead, but has scarcely broken ground in the USA.
Further distinctions are evident in investors’ manager selection policies. A significant portion of ESG-oriented investors are open to working with managers that have not yet moved far in the direction of responsible investment but are willing to change. Indeed, they present their influence on the asset management industry as a form of impact. Others, by way of contrast, require strongly institutionalised existing processes.
Several European pension funds will only accept managers that are signatories to the Principles for Responsible Investment (PRI), even in asset classes where this severely restricts the available pool of providers. For instance, in one manager selection process for U.S. small-cap equity, the European pension fund client saw their shortlist shrink from 20 to just two, simply based on the fact that PRI affiliation had become a board-mandated requirement.
This diversity of demand creates two intriguing implications for asset owners.
Firstly, it means that the same manager or strategy will more than satisfy one investor’s particular ESG specifications while falling far short for another. Generic ESG ratings or scores generated without the investor’s specific requirements in mind (by consultants, for instance) will unnecessarily limit the universe of providers from which investors can choose, translating into potential opportunity cost.
Secondly, it has resulted in very little progress towards standardisation of investment products, even in sectors where ESG integration has become entirely mainstream such as listed equity. If anything, the sector has become increasingly fragmented. Customised segregated mandates are still the ‘norm’.
Even straightforward exclusion criteria – often considered to be the most simplistic and straightforward application of ESG – vary dramatically, as do interpretations of how those exclusions should be applied. What proportion of company revenues must derive from a disqualified area in order for the stock to be filtered out? Should a tobacco screen apply only to tobacco companies or to other firms such as marketing companies, consultants or packaging producers that derive money from the sector? Participants bring different answers to these questions but often don’t have strong beliefs underpinning those granular distinctions.To a significant extent, customisation is a natural feature of a sector where different players bring deeply held, differentiated views to the table. Yet it comes at a cost. While ESG investing should not theoretically involve higher fees, according to bfinance’s benchmarks, the reality is not quite as simple. For example, many investors who would prefer pooled funds end up with (more expensive) customised separate accounts because their requirements don’t map neatly onto the universe of available options. Some investors do exempt pooled fund investments from ESG policies for precisely this reason.
In addition, recent consulting work reveals a considerable subset of market participants that would actively welcome movement towards greater uniformity at policy level, perhaps led by an independent entity such as PRI. A large number of investors and asset managers have sought to copy a version of “best practice” rather than invent their own policies. The most common exemplar today may well be the Norwegian Government Pension Fund Global: various pooled funds, and indeed many pension funds ranging from the Nordics to as far afield as Australia, have replicated part or all of this SWF’s ESG policy.
This imitation game should come with a health warning. One bfinance client discovered through experience that the Norwegian policy did not translate well into infrastructure investments, causing problems which necessitated a time-consuming change in approach. Yet, if anything, this should make a more clearly defined set of recommended parameters, written with a diverse community in mind, even more relevant.
Breadth has served PRI and other non-commercial ESG-oriented bodies well for many years. A church open to many denominations can maximise its membership and spread its message more effectively.
Yet perhaps now may be the time for such bodies to offer a more prescriptive type of leadership, particularly for the sake of asset owners that simply wish to follow a version of “best practice” consistent with their fiduciary responsibilities. Failing that, similar initiatives from the large full-spectrum investment consultants may help both the providers and consumers of ESG investment strategies to access greater cost efficiencies.
Kathryn Saklatvala is Global Content Director at bfinance.
This article contains material from recently published bfinance white paper “ESG Under Scrutiny: Lessons from Manager Selection”