- October 01, 2014
Keith Ambachtsheer’s lead article in the Fall 2014 edition of the Rotman International Journal of ... [more]
Not content to sit back and wait for the market to move, PGGM decided to learn by doing and launched its own responsible-equity portfolio three years ago. In line with its belief that sustainability pays, PGGM’s portfolio has a long-term investment horizon that integrates financial and environmental, social and governance (ESG) factors with active ownership.
The belief that sustainability pays translates, in philosophy and implementation, to an appreciation of investing over the long term, the need to integrate financial and ESG considerations, and the culture required to achieve positive investment results consistent with that ideology.
Head of responsible-equity strategies at PGGM, Alex van der Velden, says in the past few years there have been perceived positive moves in the market regarding ESG awareness, but in reality little uptake.
“People accept principles of responsible investment and there is more open-mindedness to the concept. But it is also a façade that people can hide behind and do nothing. Most funds managers are hardly doing anything, if you ask at the portfolio-manager level, it is not happening at that level,” he says.
“At PGGM we decided the only way to do it was to learn by doing – not sitting back and waiting for the market.”
Van der Velden says evolutionary behavioural change can take a generation, so PGGM took on the role of acting as a catalyst for change.
“If you look back over history, then change only occurs when people are forced to change,” he says. “A catalyst for change is needed in this area. ESG is all about what hasn’t happened yet [in terms of portfolio impact].”
One unified strategy
PGGM’s Responsible Equity Portfolio makes up 3 per cent of the overall assets of €125 billion, or 10 per cent of the equities allocation. It began life in January 2009 with €1 billion and since then has grown to €3 billion.
The strategic objectives of the portfolio are ESG integration and active ownership, with the point of integration to see how ESG could add value to – or detract value from – a company. This is implemented through better stock selection of sustainability leaders and through better management of ESG risk by catalysing ESG improvements at laggards through active ownership.
This has resulted in a three-pronged analytical approach involving fundamental financial analysis, ESG integration and active ownership.
There is also recognition that ESG analysis takes a substantial amount of time, not just to understand the specific facts, but more importantly to understand their financial relevance. This has meant that the approach by PGGM is active and concentrated.
The portfolio combines fundamental financial analysis, ESG analysis and active ownership into one unified strategy with the overarching aim of identifying companies that are financially attractive, responsible and open to engagement.
In practice this means the investment process involves financial analysis and modelling, ESG analysis and measurement, in an active dialogue with investee companies from the start.
|“You still need a finance background, but you really need that one-in-a-hundred person who is open-minded enough to make up their mind after analysis,” Alex van der Velden says.|
In a Rotman International Journal of Pension Management article, van der Velden outlines a set of eight Responsible Equity Portfolio (REP) Investment Principles, which define what it thinks companies that will thrive over the long term look like.
“They have strong management and ESG disciplines and offer good value/growth prospects at low inherent level of financial risk including low leverage, low capital requirements and sustainable margins.
“Management’s proactivity on ESG issues and strong financial metrics provide an important proxy for assessing company stability and management quality, as do openness, transparency and honesty.
“We are aware there are limits to the depth of this analysis when we approach a company as an outside investor, and that management access is essential to truly understanding a business and creating the opportunity to exercise good oversight. To achieve this access, REP always aims to be a top-20 investor to investee companies, with the corollary that companies can be candidates for investment only if senior management team meets with members of REP on a regular basis.”
In addition, REP will invest in a company only if its business model and balance sheet can be understood.
The insistence on thorough and deep financial and ESG due diligence, combined with the desire to maintain an active corporate oversight, requires a concentrated portfolio.
REP targets 15 to 20 holdings and at the moment it only looks at developed-European and North American companies. The emphasis on the long term implies that the average holding period of each investment can be expected to be many years.
The success of the portfolio remains to be seen over the long term, but in the three-year period since inception it has performed well.
Van der Velden says it is premature to report on the portfolio’s performance as it focuses on the long term, but he says one of the more enduring aspects of its success is the culture of investing at PGGM.
He says in many investment organisations ESG continues to be dismissed as financially irrelevant, but he believes a culture of open-mindedness must be nurtured in which both ESG and financial factors can be seen as critical and as correlated over the longer term.
“Any organisation starts at the top. One factor that slows progress is the extent to which pension funds are risk-based culture – as opposed to an investment focus. Investing €1 billion in an unproven strategy takes courage, and few people have the mindset to take that risk. However, our experience across other asset classes has shown us that there is a substantial early-mover advantage,” he says.
Overcoming entrenched opposition
Fellow Dutch investor APG is also taking on this approach and also has a team and a portfolio dedicated to ESG. But across the industry van der Velden says there is little pressure to change.
“There is an innovation dilemma when you do something new. Our leadership in the start-up phase was what kept us protected. When you do something different from the norm within any large organisation, there is a risk that the vested interests work against it.”
He points to a recent article in Vanity Fair magazine that demonstrates why new initiatives at Microsoft have failed over the years.
“Don’t underestimate the innovation dynamics that are at play in large organisations. There is generally an entrenched opposition to change, it is important that the top leadership is behind it.”
Daring to differ
Consistent with a long-term focus, PGGM’s portfolio had a three-year lock-up period and this allowed the manager to make mistakes without fear of repercussion.
“It takes away the short-term pressure to prove yourself. In fact the first two companies we invested in were complete basket cases,” van der Velden says. “One was a bad financial decision and the other was very poor on ESG despite our analysis. During the start-up phase we made quite a few mistakes, but overall still had a good first year. And we learned a lot and continue to do so.”
PGGM has a 10-person team dedicated to this portfolio. It also takes input from the company-wide responsible investment team, but it was important for the portfolio managers themselves to be engaged and not use overlays by another team.
“This empowers the analysts, they decide ESG is valuable or not as the case may be,” he says.
With regard to assembling the right team, PGGM’s experience points to finding the right skill set that combines a traditional finance background with an open-mindedness to look at other considerations.
“You still need a finance background, but you really need that one-in-a-hundred person who is open-minded enough to make up their mind after analysis. We have quite a young team, they have the daring to do something different.”
Van der Velden says the REP process results in a portfolio with collectively lower financial and ESG risks.
The portfolio had a tracking error of 5.9 per cent in the fourth quarter of 2011.
Because of the concentrated nature of the portfolio, most of the absolute risk can be explained by stock-specific risk. It believes the higher stock risk can be balanced by the ESG risk analysis.
PGGM has developed its own toolbox and looks at more than 80 relevant ESG data factors which reflected an absolute, not relative, measure of ESG risk.
“Except for the most egregious engagement situations, generally share prices don’t reflect ESG risks. People say it is priced in but there is still a long way to go before that is the case,” he says. “As an investor, I ask whether I am being compensated for that risk, we need to compare companies on an absolute level.”
On the ESG risk side PGGM is developing better tools to measure ESG, but one proxy for ESG risk – CO2 emissions – show REP companies emit 150 tons of carbon per €1 million of sales, while the S&P500 companies emit 473 tons of carbon per €1 million of sales.