European asset owners should agree to a fixed fund-level budget for asset manager ESG research and stewardship programmes if they want to avoid the potential attainment of their sustainability objectives being held hostage by financial markets, according to a consultancy.
The rest of the management fee would be paid on fluctuating assets under management, as is the case currently.
Frost Consulting’s suggestion is a response to its belief that delivery on asset owner ESG objectives could be derailed because of a mismatch between the long-term nature of those goals and the current mechanism for funding asset manager research and other ESG-related expenses.
In contrast to the US, in the wake of MiFID II both fundamental research and ESG budgets are primarily funded via managers’ profit and loss (P&L), which is vulnerable to weaker markets.
Before MiFID II asset owners were funding manager research budgets in addition to the standard management fee, and ESG and/or stewardship budgets by and large did not really exist.
“If there’s a bear market before 2050 all bets are off,” the consultancy argues in a reference to the deadline by which many asset owners and asset managers have pledged to render their portfolios carbon neutral.
It looked at three asset managers that have a high ESG commitment level rating from Morningstar and found that in the event of a 2008-style market downturn, in two of the three cases the profit impact was such that “the chances of them being able to execute these long-term ESG and stewardship programmes were pretty questionable”.
“The question is, how can asset owners ensure the continuity of managers’ ESG/stewardship programmes, regardless of market conditions, without increasing their costs over the course of a normal investment cycle?,” said Neil Scarth, principal at Frost Consulting.
Fixing ESG in the management fee
Its answer is its ESG Cost Plus model. Under this approach, asset owners and asset managers agree that the asset owner pays for external ESG inputs (such as climate data and proxy advisory services) within the context of the agreed management fee on a constant euro basis while letting internal manager costs such as portfolio managers, analysts and stewardship teams, fluctuate with assets under management.
“Even more sustainable”, in the consultancy’s opinion, would be to include all of an asset manager’s ESG costs, internal and external, in the portion of the management fee that would be funded on a constant basis.
“The key point here,” said Scarth during a webinar, “is that internal ESG costs, including stewardship, are rising very rapidly. Our benchmarking work suggests that many large non-ESG specialist managers have seen ESG and stewardship headcounts increase by an average of 50% since the end of 2020.”
“As markets tend to go up for longer periods than they go down, this could save asset owners money over the course of a cycle”
Neil Scarth, principal at Frost Consulting
Implementation of Frost Consulting’s model would mean an asset owner misses out on lower ESG-related fees if markets go down, but if the ESG portion of the management fee is fixed it also stays flat when markets go up, rather than proportionately increasing with returns.
Scarth has calculated that based on the averages of all of the bull and bear markets in US equities since 1949, the consultancy’s Cost Plus method would reduce total asset owner management fees by around 13% over a six-year cycle, and reduce the ESG component of the management fee by around 55% over the course of the cycle.
“As markets tend to go up for longer periods than they go down, this could save asset owners money over the course of a cycle,” he said.
Scarth acknowledged that the consultancy’s ESG Cost Plus model rests on some “pretty important fundamental assumptions”, namely:
- both European asset managers and asset owners want agreed ESG objectives to be achieved;
- many asset owners have largely delegated ESG/stewardship responsibilities to asset managers; and
- asset owners don’t want managers to reduce ESG/stewardship efforts in declining markets.
The consultancy also acknowledged that its model would require fund-level ESG input allocation and transparency, but said that this is easily achievable and also a benefit of the approach.