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ESG integration – no one size fits all

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Nina Roehrbein surveys best practice among investment managers in ESG integration

Principle 1 of the UN Principles for Responsible Investment (PRI) commits to incorporating ESG issues into investment analysis and decision-making processes.

With the number of PRI signatories standing at over 1,200, the integration of environmental, social and governance (ESG) issues could be assumed to be widespread.
But according to Eurosif’s European SRI study 2012, this relatively young ESG strategy is slow growing compared with other approaches.

The first step in ESG integration is to have faith in ESG. “No one has ever done conclusive research demonstrating that taking account of ESG issues is going to give you better returns over a period, so it is a belief rather than something that is founded in some academic work with a set of numbers that everybody accepts,” says Mike Taylor, chief executive at the London Pension Funds Authority (LPFA). “But given the faith of the LPFA and other big pension funds, and the importance of them to the fund management industry, the fund management industry has responded well to the agenda.”

But according to Matt Christensen, global head of responsible investment at AXA Investment Managers (AXA IM), plenty of academic studies have shown that, as a value driver, ESG is mostly either neutral or positively correlated.

“The conclusion is that there is no penalty for pursuing ESG, which was a concern some years ago,” he says. “And as part of the overall analysis, ESG might uncover hidden risk issues or alpha opportunities.”

“In the past, including ESG was assumed to lead to lower returns but the notion is now sinking in that applying these criteria might well enhance performance, as several studies and our own experience suggest,” agrees Rob Drijkoningen, head of the emerging market debt (EMD) team at Neuberger Berman. “Many of our clients are now under pressure to explain why they invested in a certain way.”

Pension fund clients, such as Dutch civil service pension fund ABP, have fuelled the investment beliefs of sustainability and governance for Dutch fiduciary manager APG.
Today, the three objectives of APG’s responsible investment policy are to contribute to risk-adjusted returns, to demonstrate social responsibility and to contribute to the integrity of financial markets, which includes the integration of ESG.

LPFA bases its ESG integration approach on two investment principles – being a responsible, long-term investor and encouraging ESG best practice in the companies in which it invests, as it believes this will deliver the best long-term returns. It asks for ESG integration in its RFPs and in its regular meetings with managers discussing performance and approach and strategy.

Becoming a PRI signatory in 2007 was the impetus behind First State Investments’ pursuit of ESG integration. “It is a journey,” says Will Oulton, global head of responsible investment at First State. “There is no model of best practice you can point to. It is still an evolving discipline within the industry.”

Integration of ESG works best when the investment approach is supported and encouraged from the top, allowing resources and time to be dedicated to exploring the most appropriate ways of going about it.

“Without the explicit support of our chief executive, the integration of ESG would be limited,” says Oulton. “Support from the top is not just about building a responsible investment team but embedding responsible investment in our business, including, for example, our recruitment processes.”

In-house or external?
While some asset owners and managers have dedicated ESG personnel, others refrain from having specialist ESG staff and aim for all their portfolio managers to be familiar with ESG.

Due to the breadth of its investment, APG has a dedicated sustainability and governance team but also tries to bring portfolio managers up to speed on the ESG issues in their type of investments.

Danish pension fund Unipension, which integrates ESG in its in-house-managed Danish equities portfolio, has one ESG specialist in its investment department, while several portfolio managers are expanding their ESG expertise as part of a wider integration effort.

The first port of call in ESG integration is data and passing that data on to the investment teams. Third-party data providers and international organisations such as the World Bank are typically used but, increasingly, asset managers also compile their own data.

AXA IM has invested in a proprietary platform which is based on ESG information from nine different suppliers. The platform provides information on anything from weapons manufacturers to governance risks for 3,500 companies, including fixed income issuers.

“Internally we use the information by accentuating the areas we think are most relevant to financial performance,” says Christensen.

AXA IM has also adapted ESG methodologies for use in sovereign debt, fund of funds and real estate asset classes.

Aviva Investors changed to its new ESG structure in January 2012. Prior to this it had a separate sustainable responsible investment team.

“Under the new approach, we establish the investment process and style of the fund managers, wherever they work and whatever their asset class,” says Steve Waygood, chief responsible investment officer at Aviva Investors. “We then discuss potentially material ESG issues and what data they might need. If we decide to use an external data source we conduct a full strategic review of the provider at least every two years.”

Aviva Investors’ voting record and externally compiled ESG data is uploaded into its Bloomberg terminals, enabling fund managers to integrate the ESG risks in security selection, portfolio construction and portfolio risk management.

“Sometimes external data is wrong or out-of-date by the time the analysis reaches us,” says Waygood. “Wherever we find that this is the case, we tell the research providers and factor it into our strategic review. If it was simply a case of buying external data feeds and faultlessly integrating them into portfolios any fund manager could do that but there is a market inefficiency we can exploit.”

“It is all about whether the factors are relevant to the investment case – do they have a material impact on the revenues, costs or the risk profile of that company,” adds David Sheasby, investment director at international equity specialist Martin Currie. “As it forms a core part of our research, we do not think of it as an extra or separate cost.”

APG requires that all the investment cases drawn up by the fundamentals team include ESG, in other words an assessment of the risks and a link to how that affects the view of the potential asset.

“We developed a number of tools that make information accessible to the fund managers, from external sustainability and governance research providers to internal information on votes and engagement with companies,” says Claudia Kruse, managing director governance and sustainability at Dutch fiduciary manager APG. All information is then pulled together in a web-based ESG dashboard where portfolio managers can access it. A Bloomberg tool compares the health and safety performance of a company relative to its peers, allowing APG a sector view to take account of which company has a better ESG performance. Joint engagement with portfolio managers and companies on topics deemed to be of importance complete the picture.

Unipension combines external ESG data with its own in-house research, including site visits.

First State, meanwhile, is in the process of evaluating its third-party research. “The plan is to have a core global ESG data set with various satellite data services for each of the investment teams,” says Oulton. “They each have evaluation models tailored to their particular asset class.”

A global responsible investment committee, chaired by its CEO, oversees the progress of First State’s responsible investment strategy. The lead analysts in each of the investment teams make up an ESG committee and report to the responsible investment committee.
Another internal group, which is modelled on the PRI’s Clearinghouse  will focus on knowledge building and information sharing across the group from engagement activities and will be set up in late 2013.

Across asset classes
ESG integration in equity has led the way so far – but academic and industry research has shown a trend toward developing models and tools for ESG integration across all asset classes. An online survey on ‘ESG Integration Across Asset Classes’ conducted by MSCI ESG Research in spring showed that there was a growing interest in integrating ESG factors across equities (35%), fixed income (20%), real estate (13%), private equity (13%) and other alternatives (13%).

“Over the last two years there has been a big change where we see asset owners increasingly asking for ESG integration in their RFPs across all asset classes as opposed to just in equity, as was previously the case,” says Christensen.

However, the integration of ESG is less straightforward in other asset classes, particularly in sovereign debt.

Unipension integrates ESG within equities and high-yield bonds and is developing guidelines within other asset classes including government bonds, private equity and real estate. First State has yet to incorporate ESG into its 18-month-old emerging market debt team. An ESG integration plan for the team is in the making.

Neuberger Berman’s EMD team, which joined from ING IM earlier this year, came equipped with experience in using ESG frameworks. ESG assessments make up 40% of its country ratings.

“We see ESG factors as important indicators of the resilience of a country in the face of an uncertain future,” says Drijkoningen. “And studies find that incorporating these criteria improves the forecasting ability of models for investing in the sovereign credit space. The empirical evidence shows that it adds to the quality and power of predicting where sovereign spreads are heading.”   

Neuberger Berman’s EMD team ranks about 70-75 countries, with the likes of Singapore, Hong Kong and Chile at the top of the rankings, while Angola, Belarus, Iraq, Venezuela, Ivory Coast feature at the lower end.

“It also allows us to track the improvements and deteriorations of the countries and where they come from,” says Drijkoningen. “We track the openness of the economy to foreign trade and private capital because while a country may be able to pay, it does not mean it is willing. Willingness is more embedded in political, governance and social structures than in pure direct macro fundamentals.”

APG integrates ESG in all its asset classes with a tailored approach for each class.

“In real estate or commodities, we take a different approach to equities and credit,” says Kruse. “We get involved in the pre-investment stage for alternatives. Every investment proposal above a certain size has to go through a committee for investment proposals, a process which involves the board assessing whether to go ahead with an investment, and the mandatory part of that is an ESG assessment.” There have been instances where
APG decided not to proceed with an investment based on ESG concerns.

Despite integrating ESG considerations into the advice for its clients, consultant Aon Hewitt does not attempt to build speculation about the impact of climate change, resource shortage or population growth on equity markets into the long-term views because of the sheer numbers of unknowns and variables. However, for asset classes such as insurance-linked securities, where climate change makes up part of the risk profile, it factors climate change into the price.

Tim Currell, partner and global head of sustainable investment and corporate governance at Aon Hewitt, says: “The biggest difficulty is giving ESG the correct weight in any investment decision. Sustainability should not be the only factor investors consider when making an investment decision. So when we draw shortlists of managers we do not only put the ones forward that are good at ESG integration. It is the asset owners who are in control and set the agenda.”

ESG integration does not just apply to active managers and mandates, and pension funds such as the LPFA still expect their passive fund managers to vote.

In passive investments, benchmarks such as the FTSE4Good or the DJSI can be tracked and exclusions followed. “When we track a conventional mainstream index, our duties around engagement and stewardship and voting remain,” says Waygood. “But admittedly, we focus fewer resources on those companies than we would on the very active, much larger positions.”

“In pooled investments, we can exert influence, especially when it comes to controversial companies,” adds Christensen. “We ask the third-party fund managers to review their holdings on specific companies and have a dialogue with them about any controversial issues. With mandates, we have even greater control to ensure controversial companies are monitored and, if needed, divested.”

Exclusion strategies
While engagement is part of ESG integration for many investors, exclusions are also often undertaken. Number one on the exclusion list is producers of cluster munitions.

APG’s exclusion list contains 14 companies involved in the production of cluster bombs and landmines and two other firms that appear to be acting in contravention of the UN Global Compact Principles, namely Walmart and Petrochina. Unipension excludes certain weapon producers and companies in breach of EU and UN labour, human rights and environmental conventions.

AXA IM has blacklisted several countries from its own investment universe, as well as sector specific areas such as weaponry and soft commodities. “We are working on screening out reputation risk countries using our in-house methodology,” says Christensen. “We are also divesting from soft commodities for all AXA-managed investments because it remains unclear whether food commodities add to speculative food pricing.”

Neuberger Berman’s EMD team has an exclusion list of countries that it will not invest in, including the likes of Iran, North Korea, Myanmar, Cuba and Sudan.

“For countries that are not on the exclusion list, a low ESG score does not necessarily mean we refrain from investing,” says Drijkoningen. “But we would need a higher expected return to make up for the type of risk.”

The procedure is similar at Aviva Investors.

“If the risks around apparently poor ESG practices are reflected in the price of the company, we will also invest,” says Waygood.

Taylor adds: “It is our deliberate policy not to exclude, as we have an ESG, not an ethical approach. However, if we were invested in a company that we had concerns over, we would want to understand what the fund manager had done to address those concerns and why they had invested.” For local authority pension funds, this concern is probably biggest in the tobacco area. LPFA does not mind if its fund managers invest in tobacco products but wants to understand why they have done that and what the long-term investment prognosis is.

Certain challenges remain in an ESG integration approach, above all the perceived lack of commitment and competency among the main investment consultants and the lack of available data. “The availability of quality and reliable data is a big issue, particularly with a portfolio of our size,” says Kruse. “We have about 4,000 equity stocks and not all of them are covered by external research. We hope that data coverage and the quality of the information will improve. We already witness increasing transparency in companies.”

“ESG data does not get updated as frequently as economic data,” adds Drijkoningen. “We have to rely on quarterly or even annual data and sometimes these will lag by up to two years, meaning we do not necessarily pick up change on the ground immediately.”

Time horizon or the apparent short-termism of financial markets is another challenge.
Martin Currie typically holds positions for three to five years, a timescale which, allows the impact of some ESG factors to materialise.

“Some investors still regard sustainability or ESG as an optional extra and, in extreme cases, something done by tree-hugging fanatics,” says Sheasby. “There is a strong element of short-termism in markets and for investors with a shorter-term focus, ESG may not be an issue. However over the longer term ESG factors need to be fully understood, as they can have a material and lasting impact on share price returns.”

AXA IM is already in the process of moving to quarterly updates on ESG factors for its clients.

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