Switzerland: The Swiss ESG paradox
Nina Röhrbein assesses why Swiss pension funds lag in ESG implementation, even though the country leads in terms of ESG asset management
Switzerland is known for its innovation in asset management. Asset managers such as SAM and Bank Sarasin are famous outside Switzerland for their sustainable approach.
That is why it seems a paradox that in the country famous for its sustainable products institutional investors lag as far as environmental, social and governance (ESG) is concerned.
According to the study ‘Sustainable Investments in Switzerland' by FNG Switzerland, which is part of the Sustainable Investment Forum covering German-speaking Europe, and ESG investment consultancy onValues, the institutional share of the Swiss ESG market reached 50% for the first time in 2011.
In previous years, the share of private and retail investors has consistently outnumbered that of institutional investment. In 2010, for example, institutional investors held only 39% of the assets compared to 61% by retail investors.
But encouraged by new asset classes, a couple of institutions started integrating ESG in their institutional mandates in 2011, beginning to reverse the trend.
Two thirds of the Swiss ESG market uses screening. Around 60% use exclusionary criteria, while one third is invested in thematic investments, according to FNG.
One-quarter of investors exercise their voting rights, while one-sixth does engagement and one-fifth of all investments is based on the integration of ESG.
"Integration of ESG in bonds and equities is becoming increasingly popular and can be implemented without any major restrictions," says Sabine Döbeli, head sustainability management at bank Vontobel and vice president at FNG.-According to recent surveys such as the 2011 Eurosif corporate pension fund study and the 2005 Swisscanto survey, 40% of public pension funds and 15% of private sector and corporate funds have some element of ESG in their investment activity. However, based on the experience of onValues, these are often not systematic efforts but more likely to be opportunistic in nature.
The most notable development with regard to ESG over the last 15 years has been the uptake of active ownership, voting and engagement in Switzerland, which is to a large degree the result of work by the Ethos Foundation (see article in this section) and the dominance of the Swiss Market Index (SMI) by a couple of large companies.
The increase in voting activity can also be attributed to the introduction of article 49a, BVV2, in 2009.
Ivo Knoepfel, managing director at onValues, says: "When it comes to the implementation of ESG in the investment portfolio, Switzerland is not among the most advanced countries in Europe. This is surprising in view of the leading position that its asset management industry has in the field."
FNG reported an unchanged volume of socially responsible investment (SRI) assets in Switzerland for 2011 year-on-year. At the end of December, CHF42.3bn (€35.2) in assets were invested according to sustainability criteria - around 1% more than at year-end 2010. Most of the money, 53%, is still invested using funds, but institutional investors increased their commitment over the previous year and pushed the share of individual mandates to 44%.
In the bond area, the share of assets invested according to sustainability criteria increased by 10% to 31% in 2011.
"Apart from the common active equity and fixed income strategies quantitative approaches are being adopted for the construction of ESG structured products and funds," says René Nicolodi, head of sustainable investment at Zürcher Kantonalbank, whose pension fund is one of the few Swiss asset-owner signatories to the UN Principles for Responsible Investment (PRI). "Quantitative methodologies are usually employed to optimise the products relative to conventional benchmarks and, also, to generate additional alpha from rule-based stock selection. Additionally, different emerging market equity strategies have come to market and sustainable real estate has gained more traction The realisation of sustainable commodity products continues to be a hotly debated topic. However, viable solutions for a broader market have yet to be developed."
The number of Swiss pension funds integrating ESG is small. Notable examples are the Swiss Federal Social Security Fund (AHV), which manages part of its listed equity mandates with an explicit consideration of ESG, and the pension funds of some cities and cantons such as Geneva and Zurich that have a relatively sophisticated approach to ESG. One of the largest pension funds in the country, Swiss Post, has recently implemented a large microfinance debt mandate.
"Some of the leading corporate pension funds including the ones of ABB and Novartis say that they request material ESG issues to be taken into account in financial analysis
and portfolio management by their managers but it is unclear how systematically that
is done," says Knoepfel. "Some of these corporate pension schemes have now become service providers to smaller corporate plans, meaning they have acquired a service mentality that is leading them to realise that offering an ESG option can add to their competitive positioning in the market."
Classic governance issues are now frequently embedded in Swiss pension funds, and many institutional investors have a bias towards topics such as shareholder rights and remuneration when determining relevant ESG issues. The awareness of reputational risks stemming from either environmental issues, such as BP, Transocean and Tepco, or social and human rights issues such as cluster munitions and employment conditions, on the other hand, is only slowly growing.
"However, the link between reputational risk from ESG issues and economic exposure in an investment strategy is not often systematically detected, but dealt with ad-hoc," says Stephan Skaanes, partner at consultancy PPCmetrics.
Screening remains the most popular approach among institutional investors.
"Negative screening is often less expensive, whereas a best-in-class approach applies ESG criteria to the whole portfolio," he adds.
With regard to asset classes, equity holds over 50% of the assets under sustainable management. The greater shift towards fixed income in 2011 is largely explained by the economic environment.
According to Knoepfel, real estate is probably the Swiss asset class with the highest consideration for ESG issues, due to the high building and energy efficiency standards in Switzerland.
"In asset classes such as equities, pension funds tend to take a more opportunistic approach, meaning they will consider investing smaller amounts in thematic areas such as sustainable infrastructure or resource efficiency, but not take a broad approach covering the whole asset class," he says. "In real estate, however, to which Swiss pension funds traditionally have a large exposure, environmental and energy-efficiency standards are usually high, even if an explicit ESG policy is not defined. It is embedded in the management and in the operations instead. Some banks have also launched specific green real estate funds and trusts aimed at the pension fund industry."
There are several obstacles to an increased ESG uptake in Switzerland.
Public pension funds are generally organised at the municipal and cantonal level. Pension funds that often show interest in ESG, such as the ones catering to the medical and teaching professions, are also usually organised at a cantonal level, meaning they are restricted by their size when it comes to sophistication in ESG.
The few specialist pension funds with a 100% ESG approach, such as the pension foundations Nest Sammelstiftung and Abendrot Stiftung, are active but typically smaller.
However, they have successfully attracted a new, younger generation of clients.
"ESG can be a complex topic and some smaller pension funds simply may not have the capacity to deal with it although it is part of the fiduciary duty to consider relevant risks and opportunities," says Döbeli. "Particularly with regard to voting and engagement, ESG also causes extra costs while it remains a challenge to quantify its direct positive impact on performance."
In general, few funds are large enough to assume leadership on ESG. "The good news is that consolidation of the sector is advancing rapidly so we will see larger funds as a result of mergers with other funds, which can only be positive for ESG uptake," says Knoepfel.
Another obstacle is the strong push towards passive investing due to the minimum guaranteed rate of return required from the pension system.
"As the current environment makes it challenging for pension funds to deliver the minimum rate of return, they try to make use of any opportunity to reduce costs," says Knoepfel.
The few ESG indices that are available in the market are deemed unsuitable for passive investing because they are concentrated and pension fund managers do not tend to consider them representative of the broad market.
"Passive investing, though, is not per se an impediment to ESG inclusive active ownership, a fact most pension funds do not seem to recognise," says Knoepfel.
Another hurdle stems from a bad experience with thematic investments in the early days of ESG. Some pension funds that invested early lost money after getting in at a time when prices were already in bubble territory and selling when they should not have.
Philippe Spicher, CEO at sustainability ratings agency Inrate, also casts his mind back: "In the early days, ESG was seen as an active self-contained investment concept that promised a higher performance than standard investment but the experience was not fully in line with that," he says. "It happened, but not systematically."
The early foray of ESG products into the retail market by renowned asset managers with strong distribution channels such as Swisscanto and Raiffeisen bank led to a huge diffusion of products and early adoption by individuals, meaning the private market already had a head start compared to its institutional counterpart.
"There is still lot to learn about how ESG is to be combined with modern portfolio construction - it cannot be a fully standalone investment concept, it is purely additional information that can be used," says Spicher. "Awareness has improved over the past 12-24 months, largely due to engagement pools such as PRI. But there is still a long way to go in raising awareness and educating investors."
Doubts over the credibility of ESG ratings intensified through events such as the Deepwater Horizon accident because BP was part of many sustainable universes.
Furthermore, most pension fund consultants in Switzerland do not take an active stance on ESG. While they are not criticising it, they are not promoting it either.
Knoepfel attributes the lack of enthusiasm by pension funds for ESG investing also to the fact that many of the strategies offered by asset managers have been developed for retail investors and do not meet the needs of institutionals. "We now see a positive tendency by some of the managers focusing more on pension funds and developing strategies with a stronger emphasis on active ownership and integration as opposed to screening and ethical criteria."
The current investment environment is not conducive to ESG growth either.
"The challenges for pension funds are the continued difficult investment environment with interest rates still at very low levels and unstable equity markets, while commodities do not really function as a diversifier," says Thierry Bertheau, senior relationship manager for institutional clients in Switzerland at SAM. "According to a survey by the Swiss pension fund regulator, the Bundesamt für Sozialversicherungen, costs have become a major issue among Swiss pension funds, while disclosure requirements have increased significantly. A lot of public pension funds have coverage ratios of below 100%, meaning they have to tackle a couple of major challenges which are being prioritised at the moment even though they may not be unwilling to integrate ESG."
To encourage the growth of ESG among Swiss institutions, education is essential.
"There are different ways of integrating sustainability, which might lead to a degree of uncertainty among institutional investors," says Bertheau. "Many pension funds do not know which approach to pursue, while themed funds are difficult to integrate for pension funds because they usually have a regional or a sector approach."
Products also have to be of institutional standard.
"On the provider side, approaches and services are needed that better address the requirements of pension funds," says Skaanes. "Pension funds require products that are cost-efficient, transparent and can be compared with a benchmark."
The Swiss parliament recently approved a law that prohibits banks in their commercial banking business to engage with companies that are involved in the production of cluster bombs, personnel mines and other prohibited weapons.
"They have not explicitly mentioned investment but we foresee that this will also have an effect on the investment activities of pension funds," says Knoepfel. "We are starting to see some of the banks already applying exclusions to all their investments, which is why from a reputational point of view we expect pension funds to follow suit."