ESG is a hot topic and can mean different things to different people and organizations. Contributing to the debate from different perspectives adds to our collective knowledge. In this article, Tej Dosanjh, Ed Kilcommons, and Ian Wittkopp take a point of view that asset managers should develop true conviction in their ESG approach. The article is less about the investment process and more about organisational strategy designed to meet the needs of the external environment and stakeholders – which for institutional flows is complex.
Asset managers seeking to bolster their ESG1 credentials in order to win mandates from institutional investors must change not only their investment process, but also their corporate strategy. Only then is true conviction in their proposition demonstrable.
This paper presents a point of view based on our combined experiences spanning management consulting, investment advisory, and knowledge of the financial services value chain.
This will be of interest to investment managers, who are grappling with how to be relevant in this increasingly competitive environment. We tilt towards key top-down themes that need deeper thinking as opposed to data and process, though this is no less critical.
Finally, we touch on the implications of COVID-19 on the financial system and linkage to ESG.
ESG in context
To understand the opportunity for asset managers, greater awareness is needed of the institutional investor ecosystem and the stakeholders impacted by the ESG investment philosophy. Although not exhaustive, the following is a list of key “Actors”;
- Asset owners: Pension Funds, Sovereign Wealth, Foundations, and Endowments that have fiduciary responsibility for managing large asset pools
- Board trustees: Key decision makers on investment strategy for asset pools, ultimate fiduciary responsibility and duty of care for pension assets
- The members: The ultimate recipient of cash flow from invested assets
- Investment advisors: Who in certain markets such as the U.K. act as gatekeepers when advising on pension assets. However, powers are waning as trustees and investment executives get better equipped to make their own decisions
- Data and index providers: Who support the investment process with detailed data sets to support stock screening, thematic investing and provide relevant research
- Professional Think Tanks: These organisations provide guidance, accountability, and thought leadership to the ESG community. For example, Willis Towers Watson’s ‘Thinking Ahead Institute’ publishes a yearly Global Pension Asset Study, which often highlights key opinion shifts relating to ESG.
- Asset managers (supported by the sell-side value chain): They will be looking at ever inventive ways to grow their books in an increasingly competitive environment.
There are geo-political and cultural dimensions
Asset pools in Canada, The Netherlands, Australia, New Zealand and the Nordics are arguably more engaged and influence policy in sustainable investing in a collaborative and transparent way. Their governance structures invest more on talent from, say, capital markets than other regions, thereby bringing investment skill in this area ‘in-house’. This influx of capability contributes significantly to an ESG philosophy through targeted recruitment. Through this fostering of capability, it can be inferred that some have the ‘E’, the ‘S’, and the ‘G’ implicit in their modus operandi – it’s a given.
The situation is more complex in the US. Sustainability is a big topic on the west coast, and larger pension funds such as CalPERS and CalSTRS certainly embrace ESG principles. However, it is not generally accepted across all regions of the country – fragmented at best.
Asset managers need to understand the stakeholder ecosystem, and the geo-political and cultural dimensions relevant to ESG. They must be broadly aligned with the investment beliefs of the organisation that they seek to win the mandate from.
For example, pension fund Trustee Boards and Investment Committees are now better skilled in articulating what they want from ESG as an investment philosophy. Their advisors support to refine and add detail to the art of the possible – or art of the sensible. In short, these groups can smell a pitch that has true ESG credentials and conviction from one that has a few bullet points on a presentation coupled by a windfarm graphic!
One asset manager we spoke with spent several years engaging with global pension funds in order to understand their sustainability beliefs and their investment goals. Once this had been done, they started to align a set of their own beliefs and re-engineer the investment process accordingly. Only then did they make the shortlist and finally win the mandate. It took time and an awful lot of internal ‘change management’ to succeed.
Key questions managers need to address
Do you appreciate the regional ESG sector landscape? Can you read the demand? Do you understand what your clients believe in with respect to ESG?
What are your ESG beliefs?
Investment beliefs matter. Period. Clark and Urwin (2007) identified 12 core factors that contributed to good governance in value creation for asset owners. One of the 12 is beliefs and a sub-set is ESG beliefs.2
In 2015, New Zealand Superannuation Fund (NZ$29Bn) or sovereign wealth fund stated that their ESG beliefs were just as important as their overall investment beliefs.3 The Dutch giant PGGM has put ESG at the centre of its investment philosophy since 2007, well before it became relevant today.4 CalPers in the U.S ($372Bn) spent 18 months finalising their beliefs, of which ESG is a core component.
These three examples illustrate that asset owners use beliefs to underpin their investment philosophy. Their beliefs are at the very core of how they aim to act and behave in respect of their investment decisions. There are many other institutional investors that have a similar mental model.
Does your Board, CEO and Executive team believe in ESG?
Viewed purely from a corporate perspective, becoming an ESG manager is a strategic play and so requires top-down execution.
Some early adopters appointed a Head of ESG/Sustainability; however, this role often lacked real influence. At best, it augments a functional structure. At worst, it’s an act of tokenism; simply communicating to the market that “we have one of those too…”. The industry has recognised this, and the role is changing.
Having skill and experience with qualified individuals serving in key areas of the leadership team is a decent first step. Does that go far enough? If we talk about ‘conviction’ and ‘belief’, this must come from the Board and CEO and trickle down to the rest of the organisation whereby senior management teams embrace an ESG-centric philosophy.
Larry Fink’s open letter ‘A Fundamental Reshaping of Finance’ went some way to demonstrate the importance of sustainability and climate change impact on the modern financial system.5 A bold statement considering the size of the back-book that is perhaps non-ESG.
Don’t be an ESG manager when you can’t be one. For example, if you are well renowned for your Liability Driven Investment (LDI) solutions or you run a Macro strategy that relies on non-ESG compliant investments for exposure in key geographies, ESG strategies may not work for you.
Does your investment process and supporting data link back to your beliefs and is it sufficiently differentiated?
Much has been written about ESG investment processes and the use of data for stock selection and exclusion. The index providers MSCI or S&P, for example, are well ahead of the game in doing this. Sustainalytics uniquely offer a vast array of bespoke data services that cover research and data based on screen criteria. Arguably this could be a substitute for the asset management proposition if the asset owner has a large internal team -for a fraction of the operating costs.
Measurement of effectiveness is where most of the attention is now. Certainly index providers help on this yet there are still gaps in data and common methodology, so it’s still more of an art than science.
Should you pass extra costs onto the client through a more expensive ESG fund when compared with a like-for-like non-ESG fund?
As with any other corporate strategy there are options to implement. You build or you buy. We have discussed the possibility of build. For buy, the option is to, well, buy an established ESG manager that has all the underlying ESG philosophy supported by credible investment processes. Costs can accrue rapidly with no significant in-flows.
All this considered, active ESG managers still need to be competitive. Developing processes, buying in ESG skills, and paying for highly technical data to integrate into the process is an investment that needs return.
Implications of COVID-19 on ESG
Is COVID-19 a natural ESG screen filter?
The pandemic has influenced our world permanently. For the corporate environment, COVID-19 has been a test of resilience. Professor Neil Ferguson6 commented that the COVID-19 pandemic is a natural “stress test” on institutions. This includes governments and commercial entities.
Organisations that offer nimble but effective corporate governance (the ‘G’) with a sound approach to enterprise risk management will be better positioned to survive. Others will fall away or be acquired. Similarly, those corporate entities that use unscrupulous practices (the ‘S’) in the supply chain will be more adversely impacted than their peers.
If you are an investment manager, think deeply about these questions before committing to an ESG strategy.
- Do you appreciate the regional ESG sector landscape? Can you read the demand? Do you understand what your clients believe in with respect to ESG?
- What are your ESG beliefs?
- Does your Board, CEO and Executive team believe in ESG?
- Does your investment process and supporting data link back to your beliefs and is it sufficiently differentiated?
- Should you pass extra costs onto the client through a more expensive ESG fund when compared with a like-for-like non-ESG fund?
- Is COVID-19 a natural ESG screening filter?
You will be better equipped to implement significant change, not only to investment processes, but also the DNA of the organisation - through Strategy, Transformation, Regulation, Organisation, iNnovation and Governance (our STRONG framework).
ESG is here to stay, so it’s time to move with it.
- Much has been written about ESG, Sustainability, and Principles for Responsible Investment (PRI). We typically think of “Sustainability” as a broad and overarching commitment to be good corporate actors. ESG is more narrowly focused on the Environmental, Social, and Governance aspects of being a good corporate actor or responsible investor. Finally, PRI focuses only on responsible investment practices that incorporate ESG principles. Whilst slightly different, these terms allude to the same topic and so we will use ‘ESG’ throughout this piece.
- ‘Best-practice investment management: lessons for asset owners from the Oxford-Towers Watson project on governance’, Gordon L Clark and Roger Urwin, September 2007.
- ‘Why we believe responsible investing pays off’, NZSuperFund, Anne-Maree O’Connor, David Rae and Rishab Sethi, November 2015.
- ‘Why PGGM puts ESG centre stage’, IPE, Marcel Jeucken, February 2007.
- ‘A Fundamental Reshaping of Finance’, BlackRock, Larry Fink, January 2020.
- Professor of Epidemiology, Imperial College, London