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Asset owners/ client types
Asset owners will have different requirements of how their assets are managed depending on their motivations, objectives and risk/return profiles. Depending on these characteristics, different clients will be more suited to different types of ESG investing.
The CFA Institute identifies the following key client types, drivers and associated favoured ESG approach(es). See beneath the table for the definitions of each type of ESG approach.
|Investor||Primary driver for ESG investment||Favoured ESG approach|
|Defined benefit pension scheme||Fiduciary duty||Full ESG integration|
|Defined contribution pension scheme||Fiduciary duty, personal perspectives of beneficiaries||Some exclusions, comprehensive ESG integration|
|General insurer||Awareness of financial impacts of climate change||ESG integration|
|Life insurer||Recognition of implication of lengthy investment time horizons||Full ESG integration|
|Sovereign wealth fund||Reputational risk||Some exclusions, ESG engagement|
|Foundation||Reputational risk, investment consistent with founding or charitable aims||Some exclusions, likely to ensure investment is consistent with founding or charitable aims|
|Individual investor||Personal ethics and perspectives||Screened funds, strong ESG integration|
The PRI defines ESG integration as “the explicit and systematic inclusion of ESG issues in investment analysis and investment decisions.” ESG integration is the analysis of all material factors in investment analysis and investment decisions, including environmental, social, and governance (ESG) factors. Investors may use ESG factors as a means to identify and attempt to avoid risks that may not be immediately obvious when evaluating financial factors.1
Full ESG integration
Full ESG integration broadens the scope of ESG analysis beyond pure risk mitigation to leverage ESG analysis as a means of uncovering investment opportunities. Full ESG integration ‘represents the systematic process of fully embedding financial and ESG analysis into investment decision-making and portfolio management. It can be seen as a circular approach that utilises both quantitative and qualitative financial and ESG analysis alongside engagement to make investment decisions.
Fully integrated ESG strategies tend to face fewer constraints in the form of mandated exclusions than other strategies and are complementary to fundamental active styles of managing assets. Consistent with rigorous proprietary research and active engagement. The proprietary nature of the research that goes into a fully integrated approach can make reporting and optics challenging, putting extra pressure on managers to evidence and track their activities.
Exclusionary screening is the oldest and simplest approach within responsible investing. Originally known as socially responsible investing (SRI), the original objective was to impose a set of values or preferences onto a portfolio to screen out specific sectors.
- Universal screening – exclusions supported by global norms and conventions, such as those from the UN or the WHO. Exclusion of sectors such as: controversial arms and munitions, nuclear weapons, tobacco, and increasingly coal-based power.
- Conduct-related exclusions – these are generally company or country specific and not a statement against the nature of the business itself. An example would be labour or human rights violations.
- Faith-based exclusions – specific to religious institutions, individual investors and vary by religion. Often they involve translating into practice various codes or rules for living that are set down in religious texts such as the Bible or the Koran.
- Idiosyncratic exclusions – exclusions not supported by global consensus but are unique to a region or group of investors. E.g. New Zealand pension schemes are bound by law to exclude companies involved in the processing of whale meat.
The scope and scale of exclusions can have significant implications from a portfolio management perspective, in terms of higher tracking error and active share, and unintended factor exposure.
Tracking error – the divergence between the performance of a position or portfolio and its benchmark. Tracking error is generally reported as a standard deviation percentage difference between the return on investment and the return of the relevant benchmark. See here for more detail.
Active share – a fund’s active share compares a portfolio’s holdings to its benchmark index by measuring the percentage of stock holdings in a portfolio that differ from the index. See here for more detail.
Factor exposure – factor investing chooses securities based on certain attributes. By excluding certain segments of the market, funds could unintentionally expose themselves to certain factors that are characteristic of the remaining available investment universe. See more on factor investing here.
Positive alignment/ best-in-class
Positive alignment, or best-in-class, is in many ways the inverse of exclusionary screening. A given ESG rating methodology is used to identify companies with better ESG metrics relative to their peers in a given industry. This approach is typically expressed by investing in the top decile, quintile or quartile, based on prescribed ESG criteria.
The diversity of external ESG ratings and the lack of correlation between different rating agencies can be challenging when implementing a best-in-class strategy as a given company may have a high score from one agency but a lower score from another, depending on their methodology.
Thematic investing specifically targets sustainability-aligned themes. Thematic funds can be built around long-term resource-scarcity oriented themes such as water and clean energy, or sustainable sectors like healthcare.
Common themes include:
- Clean energy
- Demographic change
The concentrated nature of thematic investing, particularly if it is based around a single theme, can sacrifice the benefits of portfolio diversification. The sectoral bias of the portfolio will drive the underlying factor exposure of the fund, potentially carrying relative performance and tracking error implications.
Impact investing refers to strategies that aim to generate a measurable positive social or environmental impact as the primary objective. Foundations and endowment funds have traditionally used impact investing strategies to fulfill their charitable objectives.
The emergence of frameworks like the SDGs (see below) has popularised and broadened impact investing beyond its historical roots. Investment strategies may be aligned to one or more of the 17 SDGs, with the ability to report on the fund’s impact and improvement using the key performance indicators defined by the SDG text.
Recommended Read: more information on the United Nations Sustainable Development Goals can be found on the UN website.
Active ownership is ‘the use of the rights and position of ownership to influence the activities or behaviour of investee companies.’2 It refers to a number of different strategies aimed at driving positive change in the way a company is managed and governed. It views the act of divestment as unhelpful in this context.
Read: PRI – A practical guide to active ownership in listed equity , pages 11-20
- Active ownership is the use of rights and position of ownership to influence the activities or behaviours of investee companies
- Shareholder engagement covers any interaction between investors and current or potential investee companies on ESG issues and strategies with the goal of improvement
- Active management is regarded as one of the most effective ways to reduce risks, maximise returns and have a positive impact on society and the environment
- Divestment alone leaves investors with no voice and no potential to help drive responsible corporate practices
- Active ownership implies a two-way dialogue
- Investors are able to explain their expectations as well as encourage actions to preserve long-term value and be better informed to make investment decisions
- Companies can provide clarification on their strategy as well as receive early warning on emerging risks and best practices
- Active ownership can be referred to as stewardship – ‘a practice which aims to promote the long-term success of companies in such a way that protects and enhances the value that accrues to the ultimate beneficiary of an investment’
- The PRI identifies three ESG engagement dynamics that it believes create value3:
- Communicative dynamics (the exchange of information)
- Learning dynamics (enhancing knowledge)
- Political dynamics (building relationships)
- Dialogue with policy makers on current or upcoming legislation on ESG and responsible investment practices is complementary to active ownership
- Measuring the impact of active ownership is challenging as the outcomes of engagement generally manifest in the long term and it is difficult to isolate ESG factors from other components
- There is increasing academic and practical evidence that shows the financial impact of engagement (see page 15 for details of three relevant studies)
- Failing to consider ESG factors as long-term value drivers in investment practice may be considered a failure of fiduciary duty
- Investors still face cultural, regulatory and practical barriers to carrying out active ownership responsibilities and duties, including but not limited to:
- Costs/ resources
- Portfolio diversification can lead to less influence on any one holding
- Potential conflicts of interest
- Lack of clarity in regulation
- Concentration of AGMs in voting season
See section 2.2 for a further discussion on engagement and stewardship.
Fixed income investors are primarily concerned with the likelihood of default, but ESG factors can also impact credit rating and affect spreads leading to short-term changes in value.
Read: PRI – ESG Engagement for Fixed Income Investors – managing risks, enhancing returns Pages 9-15. 19-21, 25-26
- ESG factors can affect the performance of a company’s bond at different levels:
- Issuer company specific risk e.g. regulators compliance, social license to operate, brand reputation
- Sector/ geographic risk – ESG factors affecting an entire industry or region e.g. regulatory or technological changes
- Multi-sector/ systemic risk – risks that do not apply to a single sector but are the results of systematic interaction between sectors
- Indirect exposures – ESG factors that affect an investments returns indirectly
- Analysis of ESG factors can help investors form a more holistic view of a bond’s value, identify improving credit stories, or differentiate bonds with similar financial profiles.
- Analysis of ESG factors can identify opportunities as well as risks – e.g. research shows that firms with strong corporate governance benefit from higher credit ratings and lower cost of capital
- The corporate transparency and third-party research coverage available to fixed income investors is relatively poor compared to public equities
- By engaging with issuers, fixed income investors can encourage behaviour designed to improve credit risk metrics and drive sustainable long-term returns
- Engagement has the potential not only to protect investor returns but also to contribute to the ‘broader objectives of society’ as defined the by the UN SDGs
- Green bond issuers tend to be more willing to engage on ESG and provide better access to management – the PRI expects that the growing green bond market will trigger more systematic engagement practices across the rest of the bond market
- Engagement activities usually fall into one of two categories:
- Proactive – investors seek dialogue to manage medium/ long–term issues
- Reactive – investors initiate dialogue in reaction to downgrading, controversy or scandal, which presents financial and/or reputational risk
- Investors can prioritise engagement based on:
- Size of holdings
- Credit quality of the issuer
- Duration of holdings
- Quality of transparency on ESG
- Specific markets and/or sectors
- Specific ESG themes
- Companies in the lowest or highest ranks of ESG benchmarks
- Specific issues considered priorities for the investor based on input from clients and beneficiaries
- A bondholder’s influence with issuers varies throughout the issuance lifecycle, therefore timing and engagement is a strategic decision
- If the debt issuance is privately placed, investors are likely to have more direct engagement and more influence
- Factors that can influence the effectiveness of an engagement include:
- Size of the investor
- Credit quality of the issuer
- Public versus private placement
- Whether the issuer is looking to reissue debt imminently
- State of the market
- Relative awareness of issuer ESG issues
- Regional and cultural differences
- Collaboration involving multiple investors engaging the same company, or investors joining forces to engage many companies on the same ESG issue, can be an effective way to gain corporate managers attention, pool knowledge, information and engagement costs
The potential for engagement with sovereign debt issuers is likely to be much more limited. Only the largest investors are likely to have any scope to influence the stance of nation states, and even then, the influence is likely to be minimal.
Direct engagement with investees on ESG matters will be undertaken by the general partner (GP) in a private equity investment, whilst the limited partner (LP) may engage with the GP on their approach to monitoring and acting on ESG issues across the portfolio(s).
As private equity investment is often in early stage companies, investors are likely to have more substantial influence over ESG related issues.
Read: PRI – ESG MONITORING, REPORTING AND DIALOGUE IN PRIVATE EQUITY pages 11-12,
- LPs may monitor GPs on ESG integration to better understand GP portfolio operations and to gain assurance that the GP is fulfilling its commitments to responsible investment practices in line with the expectations of LPs and their beneficiaries
- It is the GP’s responsibility to monitor ESG issues within the portfolio. The responsibility and knowledge to manage these issues lies largely with the portfolio company’s management
- Both LPs and GPs will benefit from a ‘bottom-up’ understanding of the ESG issues that are material to the business model, future proofing and exit propositions for a given portfolio company
- There is value for GPs to have a robust ESG portfolio monitoring system in place – as a systematic approach for identifying material ESG issues, setting objectives and regularly tracking progress. It enables them to identify anomalies and achievements; support regular engagement with the portfolio companies on issues; and strengthen company reporting practices that could have implications on exit
Infrastructure investors are exposed to ESG across the economic lifetime of their assets, across both direct impacts (such as health and safety, supply chains and the environment) and indirect impacts (such as climate change, bribery and corruption and the social license to operate).
Like private equity and property, many investors in infrastructure will work through specialist managers. In these situations, the investor’s responsibility is to monitor and engage with the manager.
Read: PRI Primer on responsible investment in infrastructure Pages 4-6
- Responsible investing is particularly compatible with infrastructure investing because of the long-term nature of the asset class and its focus on essential services
- Material ESG issues that infrastructure assets could face over their lifetime could include:
- Economic development
- Demographic shifts
- Climate change impacts
- Relationships with local communities
- Legislative and policy changes
- Environmental degradation
- Health and safety
- The materiality of an issue will vary according to factors including size and type of asset, region, operational environmental and stage of project cycle
- ESG can help identify resource efficiencies, reduce the company’s environmental footprint, drive innovation, improve community relations, protect the social license to operate and support staff retention
- Infrastructure is widely considered to have a positive social impact
- Infrastructure underpins many of the 17 UN Sustainable Development Goals (SDGs) – infrastructure investors are well positioned to make a positive impact on the societies and economies in which they invest
There is good evidence that ESG considerations have a positive effect on returns to real estate investment – a 2015 study showed that 71% of real estate studies showed a positive effect (compared to 57% of equity studies).4
The PRI identifies two features of real estate investment that make the consideration of ESG factors particularly pertinent:
- Real estate investments have long investment horizons – which is important because most ESG issues are more likely to be material when assessed over longer time periods
- Real estate investments are inextricably linked to a specific geographic location, and many ESG issues play out at a local level5
ESG index providers
There is now a wide range of ESG index benchmark providers. Indices can be customised to suit an investor’s preferences, or are commercially available in more standard versions.
Indices typically rely on rules-based criteria assessed on underlying ESG scores and metrics. These then go into a formula to tilt company weightings, or exclude entire companies, based on ESG scores and hurdles.
Indices can be used as benchmarks for active fund managers to be measured against, or as model funds for passive investors.
Single-factor ESG strategies (such as smart-beta and beta-plus) provide a passive means to weight an index towards a styles factor whilst also screening for companies that perform well on ESG metrics. The resulting products are dependent on the screening methodology and the ESG datasets used.
The major ESG indices and their approaches6:
|FTSE Russell||Rates over 4,000 securities in developed and emerging countries on 300 ESG indicators. Measures companies’ revenue exposure and management to green and brown (fossil fuel) exposure.|
|FTSE 4 Good||Applies FTSE Russell ESG ratings data to select companies with at least a 3.1 (developed) and 2.5 (emerging) rating out of 5. Companies exposed to “significant controversies” and certain business activities (tobacco, weapons and coal) are also excluded.|
|JP Morgan ESG EMD||Designed for both corporate and sovereign emerging market debt. Combines exclusionary screening against worst offenders alongside ESG ratings integration. Adjusts constituent weights based on composite ESG score for each issuer which overweight green bonds, and companies with better scoring ESG profiles.|
|MSCI ESG||Offers more than 1,000 ESG indices. Methodology is based on ESG ratings with screening criteria available (tobacco, weapons, coal, fossil fuel, Catholic and Islamic values). Governance factor measures UN Global Compact compliance only.|
|S&P (DJSI) ESG||Best-in-class indices based on an ESG assessment of 4,500 corporates. Rules-based selection of top 10% to 30% (global or regional) of sustainable market cap based on ESG score. DJSI also offers indices with exclusions screens (weapons, alcohol, tobacco, gambling and pornography).|
|Sustainalytics||Supports partner index and passive strategies (such as STOXX, SGX, S&P, iShares and Nifty) that employ different approaches (including negative screening, ESG ratings, low carbon and gender diversity).|
|Intercontinental Exchange (ICE) ESG||ICE manages roughly 40 ESG-related indices. Driven on MSCI ESG data, ICE indices – covering equities, fixed income and real estate – include:|
• thematic (environmental, water, energy);
• ESG best practices; and
• factors (such as diversity and inclusion).
|Global Real Estate Standards Board (GRESB) ESG Benchmark||GRESB ESG benchmark leverages GRESB’s position as the leading investor initiative focused on real assets and infrastructure with a focus on commercial and residential real estate.|
The nature of passive investment strategies presents some challenges when integrating ESG:
- Quality of data – passive strategies rely heavily on established data sets. Shorter time frames, lack of comparability and regional breadth of ESG data sets presents a challenge to investors
- Diversity of methodology – both at an index/ data set construction level and at the product construction level – a lack of consensus around criteria and methodology makes data sets and ESG passive products highly individualistic and incomparable
- Diversification – reducing or eliminating exposure to certain sectors represents a natural re-weight to the remaining sectors and index constituents. Additionally, excluding meaningful sectors or industries within an index will generate a higher tracking error that may dramatically alter the diversification and factor exposure of a portfolio
- Engagement and stewardship – the broader range of ownership, compared to more concentrated actively managed portfolios, makes it especially difficult for managers to engage with all the companies that they own, unless they are exceptionally well resourced, or participate in collective engagement vehicles.
1PRI. 2021. What is ESG integration?. [online] Available at: <https://www.unpri.org/fixed-income/what-is-esg-integration/3052.article>.
22018. A PRACTICAL GUIDE TO ACTIVE OWNERSHIP IN LISTED EQUITY. [ebook] PRI. Available at: <https://www.unpri.org/download?ac=4151> [Accessed 17 September 2021].
32018. HOW ESG ENGAGEMENT CREATES VALUE FOR INVESTORS AND COMPANIES. [ebook] PRI. Available at: <https://www.unpri.org/download?ac=4637>.
4Friede, Gunnar and Busch, Timo and Bassen, Alexander, ESG and Financial Performance: Aggregated Evidence from More than 2000 Empirical Studies (October 22, 2015). Journal of Sustainable Finance & Investment, Volume 5, Issue 4, p. 210-233, 2015, DOI: 10.1080/20430795.2015.1118917, Available at SSRN: https://ssrn.com/abstract=2699610
5PRI. 2021. An introduction to responsible investment: real estate. [online] Available at: <https://www.unpri.org/an-introduction-to-responsible-investment/an-introduction-to-responsible-investment-real-estate/5628.article>.
62017. State of ESG Data and Metrics. 8th ed. [ebook] Journal of Environmental Investing. Available at: <https://www.thejei.com/wp-content/uploads/2017/11/Journal-of-Environmental-Investing-8-No.-1.rev_-1.pdf>.