Two strategic asset allocation priorities are driving decision-making at the United Kingdom’s LGPS Central, the £55 billion asset manager for eight local authority pension schemes in central England. Allocating to both illiquid markets and inflation-proof, cash generating assets are the priorities as the fund navigates both runaway UK inflation – forecast at 18 per cent next year – and a shift in the saving trajectory of many of its one million beneficiaries from accumulation to income generation.

Like most other LGPS pools, Central has pooled around half (£33 billion) of its total assets so far, explains CEO Mike Weston in an interview with Top1000Funds.com. However, that belies a huge variation amongst the eight client funds’ individual pooling progress since Central was up and running in 2018, with some transferring 90 per cent of their assets – but others just 20 per cent.

It’s no reflection of a dearth of investment opportunity insists Weston, who lists asset allocations on offer spanning most flavours of public equity and fixed income alongside private equity and private debt. The next product launches comprise external mandates for direct and indirect real estate and total return.

Of all Weston’s tasks since taking the helm in 2019, deciding whether to run a new allocation internally or externally demands particular thought. Central is one of five of the eight LGPS’s pools that is authorised and regulated by the Financial Conduct Authority to manage its own assets. As an asset manager, the more Central can manage in-house the better, but internal management is far from given and for now, only comprises a gilts portfolio, private equity co-investment, passive equity and a climate focused fund that tilts to or away from companies relative to the transition.

Weston says he has developed an agnostic view to internal management, guided by client preferences. This, in turn, is governed by whichever approach brings the best net of fees performance. “To manage an allocation internally we have to be convinced we can deliver a market-matching performance, and you can’t do that in every asset class,” he says.

The quest for performance net of fees leads him to defend the UK pools that haven’t set up their own asset management organizations, opting instead to wholly outsource to investment managers. When pooling kicked off in 2016, it was assumed pools would manage most of the money in house. But persuading pension schemes focused on performance to hand over assets to new companies without a performance track record, simply because of perceived lower costs, was always going to be a struggle. “It was a false premise,” reflects Weston.

No Regrets

LGPS Central took the decision to set up a separate investment management business, going for the broadest solution to give it every opportunity to act in the best interests of clients. “There was a belief at the time we would be competing with commercial investment managers; we needed to be FCA regulated to compete on a level playing field with systems and processes on a par with the best.”

Although he wasn’t around for that decision-making process, Weston is convinced it was the right one. “With £30 billion pooled so far, we are a big investment manager. Being FCA regulated is where we should be.” Looking ahead, will Central continue to farm out more assets? “My focus is on the best interests of LGPS Central’s client funds, what products they need and what will bring the best performance,” he says.

Internal management

For all his careful pragmatism on the pros and cons of internal over external investment, Weston can’t hide his pride in LGPS Central’s new internal team, blossomed to 80-strong in the last four years. Around half work in investments, making Central a significant asset manager outside the UK’s financial centres of London and Edinburgh before levelling up became a government manifesto pledge. “We’ve been levelling up since 2018,” he says.

Team members are increasingly recruited from local universities, witnessed in the candidates making it onto the latest recruitment programme. “We’ve just had our third graduate entry cohort. We saw 150 applications for 4-5 places – it was really pleasing,” he says.

Mandating externally means LGPS Central is pouring increased resources and time into due diligence. Manager selection is focused on three key elements – people, process and performance – in a strategy designed to try and predict performance as much as possible. “It’s easy to know what the fees are going to be but it’s difficult to predict performance,” reflects Weston.

As soon as client funds decide on a strategy or asset class the team begin looking for managers, with contenders put through an internal sustainability benchmarking and scoring process before going out to tender. “Manager selection kicks off as soon as we enter the launch phase. We select managers based on performance data and multiple meetings in-person to get underneath the surface of what’s going on. It’s not a quick process; we will take as long as we need to get comfy.”

Once mandated, contact remains regular and relationships are regularly reviewed (it’s just coming up to Central’s first three-year review of its earlier mandates) to ensure managers are delivering what they promised. However Weston stresses that the relationships are long-term: changing a manager is expensive and complex.

 

Rising interest rates are placing unprecedented liquidity constraints on some of the United Kingdom’s largest corporate pension funds, prevalent users of LDI strategies. According to a recent research note from consultancy Mercer, a growing number of schemes are having to sell liquid assets like equities and investment grade corporate bonds to raise cash to maintain the level of leverage needed to ensure they can hedge their liabilities.

“To maintain leverage at acceptable levels, pooled LDI funds are issuing regular collateral calls,” says Daniel Melley, head of UK investments at Mercer. Leverage, or borrowing in order to gain more exposure to rates and inflation movements, is used within LDI mandates for risk management purposes versus the liabilities. It is also used to enable schemes to buy growth assets that otherwise would not be possible. But as interest rates track up, it is leading to losses on the gilt or swap assets held within these portfolios, in turn leading to rising leverage ratios.

Action

Meeting margin calls requires quick action, warns Melley. “In the short-term, pension funds will need to respond to collateral calls from their LDI managers in order to protect hedging levels. The key point here is that eligible assets (typically cash / gilts) will have to be made available quickly, in a matter of days.  This could be challenging, particularly where there are currency implications from selling growth assets.”

Given inflationary pressure in the economy is unlikely to abate in the short-term, it is likely that central banks will continue to increase interest rates. “If the pace exceeds the markets expectations, it will result in further strains to LDI portfolios,” predicts Melley. “A significant proportion (of pension funds) will need to act quickly to ensure they have dry powder available to meet further collateral calls, if interest rates rise further.”

Moreover, James Brundrett, senior investment consultant and partner at Mercer, warns that since interest rate rises this year have now surpassed the typical cushion set in place in LDI portfolios – a 1.5 per cent rise in long-term gilt yields – many pension funds collateral buffers are depleted. “Pension funds collateral is depleted, and we are seeing clients looking to replenish.”

The problem might not only turn pension funds into forced sellers. Some may not be able to hedge as much as they have done, and may have to accept lower hedge levels should they run out of liquid assets that could be used to top up collateral in their LDI strategies. Cue increased risk levels and potentially wider implications from a covenant, funding, investment strategy and Journey Plan perspective.

Positive

Positively, Brundrett points out that pension fund liabilities are also falling. Rising interest rates will also lead to falling liability values, potentially reducing the size of deficits and increasing the impact of contributions. “As interest rates go up hedges are losing money, but liabilities are also going down,” he says.

However, critics counter that the value of liabilities should always be seen in relationship to the value of assets, noting the value of assets may fall more than the value of the liabilities if funds have had to sell assets to meet margin calls.

“It is the difference between the value of assets and liabilities that is important, and the value of assets will fall through forced sales,” says Professor David Blake, Director, Pensions Institute, Bayes Business School, City, University of London, who argues pension funds should not be borrowing in times of economic uncertainty. “Having to sell assets in a falling market is pure speculation. It is particularly challenging if they all have to do this at the same time and liquidity disappears.”

Brundrett and Melley insist that overall LDI portfolios have passed the test of managing funding level volatility in the past decade and remain a key building block for pension fund risk management.

But important risks lie ahead. “Governance models will be called into question to see if funds have been able to react as quickly as hoped. Boards will need to know where to go if they need more collateral; if it’s not corporate bonds, where do they go?” If pension funds are forced to turn to illiquid assets, it opens a raft of new value and pricing challenges “Illiquid assets are not mark-to-market. In allocations like private equity, the pricing is out of date,” concludes Brundrett.

 

Elizabeth Fernando joined NEST as head of long-term investment strategy in November 2020. A year later she became deputy chief investment officer but is still very much focused on long term strategy.

“When I joined I went to lunch with Mark and he gave me a sticky paper with three things on it,” she says.

On that paper Mark Fawcett, the fund’s CIO, had outlined the areas he wanted Fernando to focus on: Think about how assets are allocated; how the internal asset allocation process works; and help with the development of the leadership team.

Now as Fernando talks to Top1000funds.com in a rare in-person interview at NEST’s Canary Wharf office, she says the fund is preparing to change how it allocates.

The change comes as it reviews its objectives – what it is actually trying to achieve – and how to allocate assets in line with that.

“Is a reference portfolio really the best way to do that?” Fernando says. “We’ve been working through that since I joined. It has involved looking clearly at what each asset is doing for us and whether it moves us closer to the objectives or not.”

Currently NEST is set up with three clear phases in the default fund: the foundation phase, the growth phase, and the retirement phase all of which have different investment implications.

“The foundation phase is when you first join at 22 years old and while we get them used to the idea of savings we keep volatility down. The growth phase is where members spend the vast majority of time, and then 10 years from retirement we gradually de-risk the portfolio to the at-retirement mix.”

Now, instead of having three “hard” phases the fund is looking to have a more dynamic portfolio, recognising that the needs of a 25-year old are not the same as a 50 year old.

“This will mean we will need to be more granular in how we meet those needs and take advantage of the fact we have now bigger asset size and so have more tools in the toolkit,” Fernando says.

One example is that younger members have longer time horizon and a different liquidity risk tolerance and that could mean a higher allocation to private equity, private credit and infrastructure.

“Towards the end of the year we will be talking more about a dynamic approach. The board have agreed to changing the objectives and we are working through the implementation plan now,” she says.

A more robust approach

NEST just celebrated its 10th birthday, making its first investment back in 2011. It’s first ever contribution was the odd amount of £19.65. the defined contribution fund represents the future of pension systems in the UK. One in three of the working population in the UK has a NEST account.

Employees can actively opt out but otherwise there is a mandate minimum contribution set by the government of 8 per cent made up of 3 per cent employer and 5 per cent individual contributions.

Assets now sit at around £25 billion and the fund is growing at around £400 million a month just due to contributions, not including investment returns.

It’s a good time to be reviewing the idea of the fund’s objective.

At the moment CPI plus 3 per cent after charges is the overarching objective.

“This gets you to a certain pot size at retirement. We think pensions are a bit more than that,” she says.

Other more mature defined contribution markets, such as Australia, are still grappling with the balance between accumulation and the best offering in the post-retirement phase that focuses on income.

“We have had defined benefit in this country for so long, simplistically when you say ‘pension’ to someone they think about a monthly cheque. People think they will hit retirement and automatically something happens, we know that is not the case and the sums are really difficult.”

This feeds into the idea of being more granular in what the fund is trying to achieve and while keeping the idea of investment phases, having softer edges around that.

“And if we have different objectives then what are the priorities of the different types of assets at different stages of the journey? For example the closer to retirement then there is more interest in the visibility of income and longevity so we have to make sure we’re finding the right assets to meet those requirements.”

Before joining NEST, Fernando spent nearly 25 years at the Universities Superannuation Scheme, and brought with her robust investment thinking around “making a case for investments”

“I bought with me some of the thinking about having a case for everything: why do it, why not do it, and the metrics to monitor whether we are on track or not. It helps with why you have the views you have and has driven recognition that some markets were priced for “as good as it gets” so we are bring positions back to neutral. It provides a framework for everyone to know why we are doing what we are doing, then we can have a discussion about why we are doing it and can filter out the noise. It makes things a bit more efficient.”

Changing investment allocations

NEST has started to bring its asset allocation back to a neutral position, having pushed out to an overweight position in risk assets in the autumn of 2020 when it took a view that the vaccine rollout would be a game changer for how markets would behave.

“It’s a really tough environment. We have a target of CPI+3 per cent after charges and when CPI is 1 or 2 per cent that was imminently achievable, but when CPI is north of 10 per cent it is very difficult,” Fernando says. “We think the world now is more difficult so we are bringing everything back towards neutral positioning.”

The only asset class that has delivered any real contribution to returns has been commodities in the past 12 months, she says.

Globally, the star performer for many investors has been private equity, but NEST only began its foray into private equity two months ago and has a modest 0.5 per cent allocation. The aim is a target of 5 per cent of the portfolio invested in the asset class by the end of 2024. Looking ahead, that same 5 per cent allocation to private equity in 20 years – when NEST’s AUM could be around £250 billion – would amount to around £13 billion.

NEST is not to be under-estimated with its vocal quest to change the nature of private equity fees paid by asset owners being widely successful. It has had a massive impact on the future of private equity investing, essentially reinventing what investors pay for the asset class.

NEST now has two partnerships, with Schroders Capital and Harborvest, to source co-investment deals and is not paying any performance fees or carry.

“We proved it can be done,” says Fernando.

The growth of AUM is a key attraction for managers, she says, as is the reputational benefit of being a good manager of defined contribution assets in the UK given the growth potential.

“We had an initial target of 20 per cent to illiquid asset classes but we will have another look at that and how much we can afford to invest, our younger members can have a lot more than that.”

On the horizon

With the addition of private equity, and also recently infrastructure, Fernando says there are no other asset classes to add to the mix for now.

“We did have a bit of a look at natural capital. We’ve had climate tilting on a lot of the portfolios for some time, and that seems like a reasonable extension,” she says.

From a more immediate investment perspective NEST recently did a piece of research on different inflationary regimes and what that would mean for correlations and returns.

“And at what level inflation would become problematic,” she says.

It also looked at central bank digital currencies.

“I don’t think there is anything there right now, but we looked at it in the context of some of the challenges to the financial system in the longer term,” Fernando says. “We are trying to do that longer term thinking so where appropriate it gets incorporated into the asset class outlook.”

The team is also looking at the responsibility of investing members’ money in equities given the indexed nature of investments in that asset class.

“All of our equites are indexed so we are thinking about if in an index is a sufficiently high enough bar to allocate members’ money or should we be building the bar higher? Just because a company is in the index does that mean they deserve our members money?”

The focus on this “right” to manage members’ money is something engrained into the culture at NEST.

The investment team of around 40 has a more holistic, and outcomes-focused approach than a team that has internal investments, she says.

“We have people who have thought hard about pensions in the round and what good pension design looks like and how you organise yourself to deliver that,” she says. “We are all in it for the same outcome. We don’t have performance bonuses so no one is trying to maximise their personal income. We are properly in it together.”

NEST default strategy asset allocation as at June 2022

The term “ESG” has come under attack recently in various opinion pieces, reaching the spotlight. Elon Musk told his Twitter followers that “ESG is a scam”. A Bloomberg op-ed began with the headline: “America’s Political Right Has a New Enemy No. 1: ESG Investors.”

The anti-ESG narratives go on, politicizing, and frankly sensationalizing, the term “ESG,” framing it as a left-wing agenda misaligned with investors’ best interests.

For Wespath, sustainable investment practices, those that consider the risks and opportunities related to ESG factors, have absolutely no relevance to any political affiliation.

As a faith-based, not-for-profit investor responsible for the financial security of more than 100,000 benefit plan participants and 140 institutional investors, we strongly believe long-term investment success requires a sustainable global economy: one that holistically considers the systemic risks that pose serious threats to world economic development, robust financial markets, and ultimately our investment portfolios.

We focus on integrating sustainable investment through our Sustainable Economy Framework. We recognize that the world is complex and there is no “magic formula” for achieving a sustainable global economy. We accept the validity of some anti-ESG critics who point to oversimplification or overpromising related to ESG. However, we do not believe ESG is a bogeyman, lurking out of sight, waiting in the wings to say “gotcha.” It is a proactive investment strategy where investors seek to understand how sustainable investment issues can positively or negatively affect their portfolios.

Prudent asset owners must understand how public policy may impact specific market sectors, and how political instability in certain areas of the world can affect global economies. We cannot ignore the complexities of myriad environmental, social, and governance issues that, if not adequately addressed, jeopardize the financial security of our stakeholders.

Let’s take a closer look at some recent ESG critiques:

ESG is a partisan wolf in investment clothing.

By focusing on issues that represent unmitigated risks to the global economy and the future solvency of investors’ assets, we can cut out the political noise.

For example, some may perceive certain sustainability actions, such as climate change, as political. We view climate change not as political, but as an incredibly complex issue that the world must proactively address as a danger to sustainable economies and markets. Calling on the EPA to strengthen methane management, which multiple oil and gas majors support, or addressing larger universal topics, such as the Net-Zero Asset Owner Alliance’s call for thoughtful carbon pricing, are two examples. In addition, a call for carbon pricing is echoed by a large bipartisan group of prominent economists.

That said, there are plenty of sustainable investment issues not remotely viewed as political. Community development loans that serve families, seniors, veterans and individuals with special needs and demanding opioid accountability from pharmaceutical firms are issues that we all can support. While skeptics may focus on what they believe are controversial ESG topics, we believe there are many issues where we can find more common agreement.

ESG is anti-fossil fuels

The world’s transition away from fossil fuels is laden with complexities. Fossil fuels will play an important role in fulfilling the world’s energy needs for some time. We know abandoning the fossil fuels sector would cause undue hardship on broader global society, generating negative impacts on workers and communities.

To that end, Wespath does not support wholesale divestment from the fossil fuels sector, but instead we seek to use our influence as a shareholder to enact change within oil and gas companies. Wespath has successfully accomplished this, having engaged several oil and gas giants, most notably Occidental Petroleum.

The company recently stated its intentions to become the first U.S. oil and gas major to achieve net-zero emissions from its operations by 2040 and reach net-zero for all emissions by 2050 including those generated by suppliers and customers.

ESG leads to high fees and underperformance/it is a way for asset managers to increase their fees

ESG should not be an “add-on” expense. Rather it is a comprehensive approach for achieving successful investment performance over the long-term by better understanding the companies and the systemic risks that may affect them. We maintain that the integration of sustainable investment practices should not cost more or lead to underperformance.

Rather, we expect integrating sound sustainable investment practices will add long-term value to investment portfolios. In our experience, it has done just that. Integrating comprehensive sustainable investment practices into investment management is simply prudent investing.

ESG ratings are unreliable

Investors should make their own informed decisions with the external inputs they deem appropriate— ESG scores being one potential source.

This is not dissimilar to brokerage firms’ “buy/hold/sell” ratings for stocks. ESG scores should never be the sole determining factor in an investment decision.

Wespath does not use ESG scores in its sustainable investment strategies, instead choosing to apply our more holistic Sustainable Economy Framework as our core methodology.

“Shareholder capitalism” doesn’t align with the interests of asset owners

While some reject the notion that corporations must manage their businesses in a manner that serves the interests of all related stakeholders, we recognize that the overall health of the economy ultimately drives investment performance.

A narrow view that does not acknowledge the broad impact companies can have on customers, suppliers, and other stakeholders is a hinderance to achieving overall strong economies and resilient markets.

Investors must think globally about how their stewardship resources can strengthen the economy in ways aligned with their broad and long-term economic interests. In our co-authored white paper, “The Future of Investor Engagement,” we have called on other investors to pursue such a holistic and systemic approach.

For Wespath, integrating ESG considerations through our Sustainable Economy Framework is about addressing material systemic risks that threaten a robust and thriving global economy.

We believe every asset owner has a fiduciary obligation to their stakeholders to identify and mitigate these risks. Through action, investors can create and support a sustainable global economy, one that delivers healthier financial markets, more resilient companies and greater financial security for various stakeholders.

Is this “harmful” ESG investing? We think not.

Dave Zellner is chief investment officer of Wespath Benefits and Investments.

Institutional investors are embedding illiquid alternatives ever more deeply into their portfolios in the hunt for returns. But Henrik Olejasz Larsen, CIO of Denmark’s DKK354 billion ($47 billion) Sampension, the country’s fourth largest pension fund, counsels on the importance of waiting for liquid markets to recover before adding more to alternatives.

For sure, Sampension’s alternative allocations continue to outperform listed instruments (particularly real estate and energy and transport infrastructure) and long-term, the fund will continue to allocate more to illiquids.

However, the portfolio is now un-balanced relative to set targets, and until listed markets recover, Larsen is planning to slow the build-up in alternatives. “Returns on some of the alternatives are inconsistent with moves in liquid assets,” he says. “When listed assets fall sharply and illiquid allocations don’t, we worry that less liquid markets haven’t built all that information into their pricing.”

The price differential manifests particularly in private equity fund valuations, he continues. In a bid to better measure what is really happening in its 4.7 per cent allocation to private equity, Sampension takes the last quarterly NAV from its fund managers and compares it to liquid reference indices over the same price point. “If there is a drop in liquid markets, we make a top-down adjustment in the value of our illiquid investments,” he says.

Although a crude measure of what is going on, he says this approach offers an insight into what would be the true valuation if the asset was sold today. “Private equity has a direct link to what is going on in listed markets,” he says. “I am concerned that the value set by our managers is a market transaction price that wouldn’t be realised.”

Positively, the concept applies the other way around too. It leaves him anticipating an upward spike in illiquid valuations that have still to mirror positive moves in liquid markets. None more so that Sampension’s holdings of renewables infrastructure (part of an 11.4 per cent allocation to real estate, land and infrastructure) set to benefit from sharply higher electricity and gas prices.

Tactical tweaks

Larsen espouses the importance of building a portfolio that can withstand large movements without necessitating short term corrections in an investment approach that draws on a rich store of experience. He joined Sampension in 2007 on the eve of the GFC. Back then the fund had traditional defined benefit guarantees and the crisis triggered a swathe of portfolio adjustments.

More easily said that done, avoiding all forced liquidation at the worst time is now deeply carved into his construction philosophy. “When markets go down you should not retain your risk. But you should have the option to be fully invested and increase your exposures.”

Nonetheless, the current investment climate is prompting a few tweaks here and there. Over recent years he has steadily added inflation protection. Linkers have been included in the strategic asset allocation since the start of the year and he’s gradually shifting a portion of the low-risk bond allocation to global real estate.

The process has required manpower and careful consideration around not concentrating investments in particular yields, he says. “We will continue with the strategy, but it does depend on where you enter the market so we want to spread this over several years.”

The fund has also moved towards less liquid instruments in the traditional bond portfolio in response to elevated spreads. Favoured allocations include AAA CLO tranches over investment grade corporates or European government bonds, for example. “The spread between mortgages and Danish government bonds has widened, as it has for asset swaps and Danish vs German government bonds,” he says.

Value bias

Larsen continues to favour Sampension’s value bias as a fundamental driver of equity returns at the fund. The allocation has become closely linked to interest rate movements where rate rises continue to cause value to outperform growth, thanks in the main to rate rises tending to hurt growth companies more because their cash flows are longer duration.

“It’s benefited us,” he reflects. Still, if the value allocation continues to perform as well at the end of this year as it did in the first half of 2022, he may begin to take the allocation down.

That decision will also be informed by the fact today’s underlying driver of the value allocation doesn’t fit with Sampension’s overarching philosophy: to find out-of-favour investments that provide value for money in the listed space. It’s why, for example, Larsen doesn’t like crypto or gold, both assets that lack strong underlying cash flows and rely more on market increases.

“Our value strategy is not about buying everything indiscriminately,” he continues. “In equities we use statistical key numbers derived from equity valuations as an investment guide and we assess if structural factors could give rise to numbers being skewed.”

In a final reflection, he advises on the importance of board and senior management buy-in to the thought-process underlying value investment. At Sampension this proved key when the pandemic struck. “This saved us a lot; we weren’t forced to sell in the spring of 2020,” he says.

ESG

The value bias also helps protect the portfolio from the risk of over valuations in ESG and companies puffing up their green credentials. Sampension is pouring more resources and time into ESG data collection and analysis (using internal and external expertise) than any other investment process in a bid to measure its 2050 net zero progress.

“ESG is where we are doing most new stuff. We want to use granular ESG data in a more systematic fashion that will give insight on the portfolio at an aggregate level. We are spending money on this, putting in manpower and buying data and systems.”

In a whole portfolio approach, strategy is focused on buying and engaging with companies it thinks it can improve and only screening out those it doesn’t believe will change. “We stay invested in the sectors that matter the most,” he says.

Emerging equities

Of late Larsen’s focus has also honed on Sampension’s 15 per cent, externally managed allocation to emerging market stocks. For years he’s favoured a structural overweight to emerging markets on the basis that economies that grow fast experience high returns in equity markets – but now he’s not so sure.

“I see no evidence of a link between the growth of an emerging market economy and the listed market – this is not something I am optimistic about anymore,” he says.

He is also wary of large China weightings in emerging market equity allocations given governance issues in Chinese corporates and geopolitical tensions. Instead, he favours allocations to developed market corporates with exposure to emerging markets. “We are tilting the portfolio this way,” he concludes.

 

 

 

 

ESG has enjoyed uninterrupted growth as a factor in the investment mix since its early days almost two decades ago. But this year it has been going through an identity crisis, dogged by doubts, with some commentaries suggesting that it could be in retreat. Some of these arguments are welcome as they point to the need for change as we adapt to its limitations and continue to develop.

However, dismissive and often oversimplistic talk about ESG implies a misunderstanding of what it stands for at best and, at worst, risks derailing the many industry efforts towards greater sustainability. Executing on sustainability impact is a primary industry goal and ESG activities are still the best route we have for achieving it, despite its limitations.

ESG limitations

As a very broad-based concept, ESG’s relevance and potential influence is likely to be forever contested. The versions described by various commentators vary widely and straddle both financial value and non-financial values and it is easy for ESG talk and thinking to be muddled and its outputs pigeonholed. It is also heavily embroiled in politicisation, witness its current place in the eye of a particularly challenging US political storm. It is also heavily engaged in regulation, with the SEC particularly active at present in promoting corporate reporting of climate risks and challenging industry overclaiming of ESG credentials.

Critics legitimately draw attention to all these issues and ESG advocates should be prepared to respond and mount a defence by thinking through these critiques, engaging to raise their game and adapting. This critical chatter has built up precisely because ESG has become so central and can no longer be ignored. Indeed, those that contest its value often do so from a concern that it will permanently divert attention, and business, from their version of the industry. So rather than criticising ESG in areas where it still has far to travel, more airtime should be given to refining its role and relevance for the coming era.

For a start, we must find a better way of labelling the conversation; position it within constructive and effective regulatory footprints; and connect it to real-world impact in which investing genuinely moves the needle on the environment and other key societal goals.

ESG RIP?

We start where others have, in suggesting that the term ESG may be coming to the end of its useful life. The simple concept we should foster is what does it mean to invest sustainably – achieving long-term success with inter-generational fairness built in. The three-letter moniker ESG does not represent this.

ESG of old worked on shareholder capitalism whereas investing sustainably is set to work with an increased weight on stakeholder capitalism, where fairness must be considered more widely and more inclusively alongside increased attention to the systemic risks, where these are rising especially in relation to climate change.

Investing sustainably reflects asset owners and asset managers justifying their license to operate – the social code of behaviours that governs them – and earning the trust of stakeholders by doing ‘the right thing’. This contrasts with ‘the right thing’ from a past era, which was centred on successful investment performance. This past version looks flimsy in the future era of mutual flourishing in which financial outcomes are balanced with environmental and social outcomes, and not just a dogfight for bragging rights on performance.

Here we confront a critical crunch. Moving beyond the impact of these ESG risks on the portfolio to consider the impact of the portfolio and the assets in it on the world. ESG of old only fought climate risk, whereas sustainable investing of the future means ESG must evolve to fight climate change if it is to maintain its relevance. This is certainly true for asset owners with net-zero pledges but is also relevant for others too that have broadened their organisational purpose.

Sustainability 2.0

What is needed is a step up of sustainability commitments by investment organisations. This is not to unwind what has gone before. The integrated ESG approach, with all its imperfections, has been a positive journey and those activities will continue to provide investors with return and risk benefits. These will gather strength as regulations reinforce the reporting transparency and discipline that are critical for this type of investing to be genuinely effective.

But integrating ESG is too simple a discipline for aligning investment strategies with sustainability realities, which requires making a real-world impact directly or via investee companies, so fighting climate change not just managing climate risk. To be effective ESG should effectively funnel together sustainability, impacts and longer time horizons in a significant step forward in our existing practices.

This step forward should come from a new mind-set, model and measurement framework, consistent with the theory and principles of universal ownership. The mindset shift is about seeing opportunities as if from the perspective of large asset owners whose portfolios own a slice of the world market. This involves seeing company externalities as portfolio-wide and system-wide risks and costs and seeing systemic risks as needing to be addressed because the returns required can only come from a sustainable system.

The model shift means employing the 3D investment model in which risk, return and real-world impact are integrated. In this model fiduciary duty is covered as there is no diminution of the primacy of financial outcomes because sustainability impact is instrumental to those ends. How will this extra dose of impact be delivered? Largely via strategies that emphasise active ownership and industry and public policy engagement, implying a considerable shift in resourcing.

The measurement shift will be witnessed by success being judged more broadly, rather than an obsessional focus on outperforming the benchmark. So, progress in this area will be presenting a balanced scorecard of hard and soft measures, inputs and outputs, data looking backwards as well as forwards and covering both financial performance and sustainability.

Stepping up

Stepping up will require significant change and will be hard because we have to give up some of the hiding places from where we have operated. This is a big ask and will require industry leadership from those organisations which have the culture and capabilities to put universal ownership theory into practice and start moving ESG into the real-world impact era. The beauty of the theory is that quite small numbers of organisations can create the trickle-down conditions for larger scale change.

At a time when all industries seem to be facing their ‘Tesla moment’, reimagining ESG may turn out to be our industry’s defining moment that mobilises us to do our best work ever.

Roger Urwin is co-founder of the Thinking Ahead Institute.