Author: Matthieu Mougeot
In our market outlook “2019 Themes & Opportunities ”, we identified “sustainability gaining momentum” as a major theme for investors in the coming months and years. Responsible investing is not a new topic per se. Key criteria related to Environmental, Social and Governance (ESG) aspects have been included by a growing investor base over the years. Indeed, nowadays there is increasing pressure from governments, regulators and individuals on asset owners and asset managers to adopt a broader perspective on risk and opportunities – including responsible approaches. Apart from fulfilling stakeholder expectations, investors see a number of benefits related to responsible investments – including better performance. All these factors have resulted in an increasing number of investors who introduced responsible investment approaches into their pension plan strategy.
Consultants at Mercer have advised investors on ESG topics for more than 15 years and demonstrated their commitment to the Principles of Responsible Investment (PRI). This involvement took on a new dimension last year when Mercer joined the “Aligning Retirement Assets” initiative launched by the World Business Council for Sustainable Development (WBCSD). The goal of this initiative as stated by the WBCSD is to “encourage responsible retirement plan investments since thoughtfully considering ESG factors in investment processes can result in improved risk-adjusted returns for participants and beneficiaries over the longer term”. Mercer joined the initiative’s steering committee together with other WBCSD partners such Allianz Global Investors, BlackRock, Legal & General Investments, Natixis and the Principles for Responsible Investment. One of the first results of this collaboration is “Aligning Retirement Assets Toolkit #1, the responsible retirement plan opportunity” , a paper recently published by the WBCSD and Mercer.
In the following, we would like to introduce you to the various approaches to responsible investing, discuss how such approaches can be implemented in pension plans and reflect on their potential benefits in terms of risk and return of investment.
Different ways to approach responsible investment
To make proper investment decisions without compromising return expectations, institutional investors need to establish a proper framework for their responsible investment objectives. Therefore, let’s define what is typically addressed under “ESG” considerations. Although there is no comprehensive list of ESG topics to be included in investment decisions, figure 1 highlights some of the most predominant issues to consider.
Figure 1: ESG issues to be considered. Source: Mercer, the ABC of ESG
Based on these aspects, we identified four main approaches to responsible investing: integration, stewardship, investment and screening (figure 2).
Figure 2: Approaches to responsible investing. Source: Mercer, the ABC of ESG
Integration means considering ESG factors as an integral part of the investment process. This approach starts at the investment managers’ level where ESG issues are actively and explicitly included in the research and security selection process. We can identify two main drivers to this approach. First, integrating non-financial factors such as governance or sustainability policies into the fundamental analysis can help identifying items which could have a material impact on the holdings. Secondly, companies which do not include sustainable considerations in the management of their operations might be exposed to significant additional risks (e. g. physical, regulatory, reputational) which could impact their financial performance both in the short run and over the long term. Therefore, integration can be seen as an additional way to both generate alpha (outperformance) and to add further risk management in the security selection process.
Stewardship, also called “active ownership”, refers to an approach where asset owners and creditors have a say on the activities and decisions of the institutions they are invested in. The most obvious way to express stewardship is to use proxy-voting rights attached to the holding of securities. Other investors might also engage directly – publicly or in private – with the company’s management to address issues related to sustainability. For “smaller” investors it is usually more efficient to express their voting rights via third-party providers. This way the influence of several asset owners is combined in order to give more weight to their vote on strategic issues.
Investment, sometimes also referred to as “impact investing”, describes the approach of investing in funds or projects with an explicit sustainability goal, for example social (affordable housing, microfinance …) or environmental goals (energy efficiency, waste reduction …). These strategies can be applied through funds which will select securities or projects with positive impact on sustainability issues. Alternatively, one can invest directly, for instance in “green bonds”, i. e. funding projects with positive environmental benefits, or in companies committed to improving certain ESG issues.
Screening is often the starting point for responsible policies drafted by asset owners. We differentiate between negative and positive screening. Negative screening aims at avoiding companies that have a direct negative impact on society, e. g. companies involved in the production of military material, tobacco or alcohol. Negative screening is often motivated by reputational and ethical considerations, though some argue that avoiding certain sectors or companies could also be financially beneficial in the long run. Positive screening relates to the inclusion of companies which have a high ESG “score”.
Obviously these four approaches, which form the basis of any responsible investment framework, can be implemented individually or in combination.
Responsible investing – Don’t ask why, ask how
Although currently there are no binding regulations for sustainable investing with regards to pension plans in Switzerland, it seems that the topic is highly relevant for both public and private pension funds. In its 2018 study “Swiss pension funds and responsible investment” , the WWF highlights how the largest pension funds in Switzerland are currently positioned with respect to responsible investing. Interesting to note is that some of the funds are rated as either Best or Good practice by the WWF. It proves that more and more pension plan participants want their pension plan assets to be aligned with their own personal values. In addition, plan sponsors recognize the potential benefits of implementing a responsible approach into their investment strategies as well as the potential risks of not doing it.
We had many conversations with pension fund committees over the past few months. For those who have not started yet to implement a sustainability framework the major question is often “how” to do it. As a first step, we advise institutions to check their investment philosophy and beliefs against the four approaches described above. From a simple screening to a fully integrated approach, the required resources and the impact differ quite significantly. Once the underlying approach has been validated, it should be reflected in the investment policy guidelines of the plan. Finally, an investment plan that reflects the respective responsible approaches should be drafted and implemented. As with every important decision, the question of outsourcing versus insourcing might be addressed, depending on the availability and experience of internal resources dedicated to ESG.
What about the investment performance?
When it comes to understanding the financial impact of responsible approaches, investors often hold prejudices. A common belief is that by limiting the opportunity set the return potential is affected in a negative way. However, thanks to the increasing availability of data, more and more research from both academics and practitioners demonstrates the financial benefits of responsible investing.
The number of indices with ESG approaches offered by large providers has grown tremendously. As of now, their track records cover a decent time span so that proper analysis is possible. Moreover, these records can be relatively easily compared to their “traditional” counterparts. The Blackrock Investment Institute, for example, recently compared MSCI ESG-focused indices from 2012 to 2018 to their traditional counterparts. The results show that ESG-focused indices matched or even outperformed traditional ones on an annual basis (figure 3). Similar findings were observed in the fixed income asset class.
Figure 3: An ESG Lens for Equities: comparison of traditional equity benchmarks and backtested ESG-focused counterparts by region, 2012-2018. Source: Blackrock.
These results as well as the overall development are promising as they not only encourage investors to consider applying responsible guidelines in their processes but also help investment managers to develop ESG-focused products. And the shift is real: Sustainable investments have grown tremendously from a total of $453 billion across European and U.S. mutual funds and ETF’s in 2013 to more than $760 billion today (source: Blackrock Investment Institute). As a result, the constant broadening of the investment universe will provide asset owners with more opportunities.
How can Mercer help you?
Mercer relies on the expertise of more than 2,200 investment specialists worldwide, including local specialists servicing our clients. Should you consider developing a responsible investment framework for your portfolio, or should you need a review of current allocation from a sustainable point of view, Mercer capabilities would be very well positioned to assist you.
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