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Kathryn Saklatvala, bfinance

ESG considerations becoming increasingly important to manager selection

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Environmental, social and governance (ESG) considerations continue to rise strongly in importance among investors, with ESG criteria increasingly being used across all asset classes, not just public equity.

Diversity of demand, with a huge variety in investors' interpretations of ESG, makes standardisation difficult and suggests a bespoke approach to manager selection will yield the best results, according to bfinance’s latest Market Intelligence paper, “ESG Scrutiny: Lessons from Manager Selection”.
 
Overall, the universe of products and strategies is shifting away from negative screens towards bottom-up factor integration and active engagement, yet each of these can take many forms and exclusions remain vital for many institutions. The number of ESG offerings continues to rise and the marketing has become more sophisticated but it’s increasingly important to distinguish between box ticking and substance.
 
The paper draws on insights from five recent customised manager searches in public and private markets, with detailed case studies on a private debt selection exercise for the UK Environment Agency Pension Fund and a public equity search for a European family office: two asset classes which sit at opposite ends of the spectrum in terms of the extent to which ESG has become embedded and marketed.
 
There is a growing importance and continuing evolution in sustainable investment. What started as socially responsible investing, screening out ‘sin stocks’, such as tobacco and gambling, has evolved with deeper integration of ESG risks and opportunities into investment analysis, thematic ESG investing focusing on areas such as climate change and water scarcity, and impact investing, where the intention is to generate a beneficial social or environmental impact alongside financial return.
 
Investors approach ESG from a variety of perspectives. Some have an ethical stance, others approach the subject from a pure risk management perspective. A number of investors may desire a high degree of activism, others do not. A significant portion of ESG-orientated investors are open to working with managers that are still refining their responsible investment approach, while others require strongly institutionalised processes.
 
Several European pension funds will only accept managers that are signatories to the Principles for Responsible Investment (PRI), however this can significantly reduce the number of managers in any particular search.
 
Given these variations, generic ratings on the quality of a manager’s ESG practices do not map out easily so when scoring managers on ESG, an approach that is specific to the individual investor can significantly increase the universe of providers.
 
A good example is bfinance’s private debt manager search for the UK Environment Agency Pension Fund (EAPF). The fund was realistic, recognising that the typical sector mix in private debt limits how material ESG issues are in many cases and that the industry is generally at a fairly early stage on ESG integration. With this in view, bfinance allocated basic ESG indicators a relatively low weighting and implemented a scoring system that would not preclude managers without these blunt indicators from progressing and also took account of managers’ culture and practices. The winning debt manager was not rated by any of the large investment consultants and the manager was not a PRI signatory, although they indicated their intention to become one.
 
This trend was clear from the searches that form the basis for the analysis in this paper and a good example was the public equity search for a major European family office. Going beyond exclusion and basic categorisation, deeper quantitative analysis and qualitative analysis revealed multiple dimensions of ESG integration and managers can be roughly categorised as having a simple or more complex approach across a range of criteria. Examples include whether research and inputs are external or are internally generated and proprietary, whether initial decision making is based on a straightforward overlay screen rather than being embodied in multiple dimensions, and whether the manager has generalists or specialist ESG personnel.
 
However, screening and negative exclusions are not going away any time soon. In the case of global equities, bfinance does not view exclusion lists as being necessarily detrimental to effective portfolio construction relative to a standard global equity benchmark, yet this may not be the case in other geographies or asset classes, e.g. a Canadian equity mandate that excluded oil-related stocks would not have access to around a quarter of the market. One particular area of growth within screening is the rise of Sharia-compliant strategies for listed equity.
 
Kathryn Saklatvala (pictured), global content director and report co-author, says: “Clearly investors are giving greater weight to ESG criteria, not only in equities but increasingly across all asset classes. Yet their needs and priorities are very different, leading to greater fragmentation of the sustainable investing industry even as it grows. The number of ESG offerings continues to rise and the marketing has become more sophisticated but it’s increasingly challenging to distinguish between box ticking and substance. There is a need in manager searches to dig beneath increasingly sophisticated window dressing to assess actual practices.”
 
Niels Bodenheim, director of private markets, says: "In searches such as the one we conducted for the Environmental Agency Pension Fund, we allocated a relatively low weighting to basic ESG indicators in the initial assessment and implemented an approach that would not preclude managers without these blunt indicators from progressing to the later stages of the process, where ESG considerations came to the fore.
 
“One manager in the final 10 in the Environment Agency Pension Fund's private debt search claimed to be very focused on ESG. They are members of many relevant organisations including PRI, they have a dedicated impact team and they are scored highly on this issue by other consultants. But when you dig into the role that the team plays in the process you get a different picture. You also need to hear from a range of people: if the ESG person comes and presents then of course you will hear that ESG is fundamental. You need to question the people that are doing the transactions day to day. You also need to hear from the people who do the monitoring. The approach to work-out – how the manager treats distressed situations – is very important with private debt and very much has an ESG dimension: is it consistent with ESG principles, i.e. not fee-generative but really involving working with the companies to make sure sustainability and governance aspects are high priority?"
 
Joey Alcock, senior associate, public markets advisory team, says: “While there are clearly a myriad of different reasons driving this heightened interest from asset owners in ESG-integrated investment approaches over recent years, we strongly emphasise that the assessment of a manager’s ability to generate performance should still remain front and centre for trustees. 
 
“Investment management is an expensive service and regardless of capabilities around ESG, retaining a manager delivering persistently mediocre performance is not in the net interests of beneficiaries.  As the universe of managers offering active ESG-integrated equity strategies continues to expand, the challenge to identify those which will deliver on both dimensions becomes increasingly complex.” For investors taking their first steps into ESG-integrated investing, it doesn’t hurt to navel-gaze a while beforehand so as to ensure that all objectives being targeted (including non-return/risk related objectives) can be achieved consistently with one another. 
 
“For example, it is arguably difficult to reconcile a desire to effect positive change at ESG-challenged companies through engagement with the systematic screening of such companies from the portfolio via an exclusion list. Equally important is the need to clearly articulate these objectives to your asset consultant and potential investment managers so expectations are clear up front."

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