The incorporation of ESG factors within the investment process has evolved from a nice-to-have to a necessity. Client demand has grown strongly, with 68% of the PRI’s asset owner signatory base addressing ESG considerations in their requests for proposals (RFPs). This means that many asset owners expect investment managers to include financially material ESG factors within their funds and investment strategies. In addition, policy makers around the world are introducing regulatory requirements for both investment managers and asset owners to disclose and report on responsible investment practices.
A growing number of asset owners now expect their investment managers to incorporate ESG factors into their investment processes. This means that ESG needs to be at the core of the relationship between the asset owner and the investment manager – and that ESG considerations need to be addressed at every stage of that relationship, from setting the initial investment strategy, to drafting requests for proposals, to selection, appointment and monitoring.
Thorough and consistent monitoring is critical to ensure the delivery of the terms and conditions on which the manager was appointed and that it is meeting the asset owner’s requirements. Regular monitoring of and reporting by the investment manager will provide the asset owner with insight and necessary detail to understand the manager’s approach to responsible investment, its alignment to the mandate and the investment management agreement (IMA), and to its stated investment principles.
Leading practice is developing quickly. The 2019 PRI Leaders’ Group provides examples from asset owners in our signatory base who have demonstrated leading practice in monitoring (see Box 1: The PRI Leaders’ Group).
Asset owners increasingly include ESG considerations in their investment management agreements (IMAs) and other legal documentation. More than two-thirds (69%) of PRI asset owner signatories typically implement ESG
requirements in contracts such as IMAs and limited partner agreements (LPAs).1 To ensure that investment managers abide by their clients’ ESG requirements, certain legal aspects are becoming standard features of the asset owner-investment manager relationship.
The PRI believes that ESG should be at the core of the relationship between the asset owner and the investment manager. To reflect the importance of these issues, clauses like those set out in the sample ESG clauses section of this document should be included in the agreements governing that contractual arrangement.
A Greener Fiscal Future? Looking Ahead, Governments’ Stimulation Will Be Concentrated in Pursuing Environmental Goals
With fiscal policy now the dominant lever supporting growth in most economies, it has become even more important to understand how the various fiscal policies will flow through to GDP, inflation, and different markets. We have been working to get our understanding of fiscal policy to the same level as our understanding of monetary policy. This is a difficult task, as fiscal comes in so many forms, each having different implications at the macro and micro levels. Some policies can be clearly counter-cyclical (the best of these are typically direct checks and shovel-ready infrastructure), while others aim to address more structural problems (like low productivity or environmental issues) but are less effective cyclically, as they are typically longer-term.
Against all odds, there is an air of optimism in 2021. The world feels a little different, a little bit more hopeful, even in the face of a global pandemic. We have entered a new era in US politics, and the inauguration of the Biden-Harris administration brings renewed hope for sustainable investment, particularly climate policy both in the US and internationally.
Clearly, there is much to be done. The government and the private sector need to work together to tackle the pandemic, address climate change and to build back better. We need a global economic recovery that includes a new social contract, creates green jobs and delivers economic prosperity for the many, not just the few.
Investors in the United States—and around the world—are now looking closely at the new administration and its policy directions. Although it is still too early to predict the impact of the new administration on sustainable investment, we are seeing positive signals. On his first day in office, President Joe Biden hit the ground running. He issued an Executive Order to re-join the Paris Agreement, to protect public health and the environment, with a list of agency actions to review including Financial Factors in Selecting Plan Investments.
Ahead of Earth Day on 22 April, President Biden also announced plans to host a global Climate Leaders’ Summit, a sign of the new President’s commitment to strengthen America’s renewed climate goals.
In addition, he has set goals to achieve a carbon pollution-free power sector by 2035, which puts the United States on an “irreversible path to a net-zero economy by 2050”. The US will also “promote a significant increase in global ambition” around the Paris Agreement goals. The order starts the process of developing America’s “nationally determined contributions” under the Paris Agreement, as well as a “climate finance plan.”
Following the Trump administration’s efforts in recent years to roll back progress on ESG investing, however, the future standing of the US in the responsible investment movement hangs in the air. Compared to progress in Europe and Asia, the last four years have seen the decline of the integration of ESG considerations in US investment policy and regulation.
US policymakers now have a unique opportunity to advance new policies that support sustainable investing and strengthen accountability, good governance, and shareholder rights.
The PRI wants the new administration to reverse the course that had been set by American regulators over the past few years including a 2019 executive order from President Trump which directed the Department of Labor (DOL) to review regulation of private retirement plan fiduciaries (or “ERISA fiduciaries”) with an eye towards promoting the oil and gas sector. In response, the DOL proposed rules that, if finalised as proposed, will make it harder and more costly for ERISA fiduciaries to integrate ESG factors into their investment actions and participate in proxy voting aimed at advancing corporate responses to investors’ demands on ESG factors.
A new Congress will have the opportunity to overturn the rule through the Congressional Review Act. The need for congressional intervention won’t stop at the DOL — the Securities Exchange Commission (SEC) recently finalised rules that make it more difficult for investors to participate in proxy voting to advance ESG factors. The PRI responded to both the DOL and SEC.
Another priority should be establishing mandatory ESG disclosure for publicly traded companies. Investors need access to consistent, comparable data about material ESG factors to efficiently incorporate that data into their investment practices. The SEC could mandate such disclosures, or Congress could direct them to institute these requirements.
Reform is also needed to modernise fiduciary duties. Specifically, American regulators should require pension and investment fiduciaries to integrate material ESG factors into their investment processes. Altogether, laws and regulations from the DOL and SEC need to be updated to eliminate any uncertainty that fiduciaries have an obligation to consider ESG issues.
It is promising to see the commitment to progress already demonstrated by the new US administration. Coupled with public counsel from the responsible investment community, including the PRI, we look to the new President to step up and demonstrate real leadership on responsible investment, for the sake of both people and planet.
Fiona Reynolds is chief executive of the PRI.
The COVID-19 crisis and associated lockdowns may be the crisis that the industry needed to shake-off old inefficient processes and bring in a new era of technology-induced efficiency.
According to Rick di Mascio, founder of Inalytics the crisis has accelerated the industry’s adoption of technology for manager due diligence, an area where it has traditionally lagged.
“The industry has been slow in the past to adopt technology and the efficiency that brings. Lockdown has accelerated that process and as an industry we are much more comfortable in using technology effectively,” says di Mascio.
Di Mascio believes managers and asset owners are more open to doing things differently and to the efficiency that technology can bring, alongside their qualitative measures.
As an example of the efficiency technology can bring, Inalytics is currently conducting a search where 62 managers have been contacted and they can all be analysed in four weeks.
“We could never have got through that amount of information in such a small amount of time.”
He says the adoption of technology needs to be put into the wider context of technology use, where data and technology have become more accepted in everyday life.
“Lockdown has shown there are things in data science and analytics to significantly improve the due diligence process. In the past it was a nice to have, now it is seen as increasing efficiency.”
Di Mascio, who has spent more than 40 years in the industry in roles with the British Coal Pension Fund, Abu Dhabi Investment Authority and Goldman Sachs, says the industry is predicated on the assumption that skill exists, but it lacks tools to adequately assess that skill.
“The tools that people use look at track records, which are useless. They tell you what happened in the past not how those track records came about,” he says.
Di Mascio is critical of the industry’s over-emphasis on the “three Ps” in the manager due diligence process, saying it is a critical part of the process but doesn’t address whether a manager is actually skilful or not.
“It is too strong to say it’s unnecessary to look a manager in the eyes in their office in NYC, you have to be able to trust them. But as a way of identifying skill I don’t think it does the job,” he says, adding that type of due diligence addresses a different need – to establish trust and confidence.
“You have to know that stuff – who they are, what they believe in and how they go about things. But they are peripheral to the central question of do they have skill,” he says. “The Ps don’t say anything about whether they are doing well. You have to know it but it doesn’t address the key question, are they good at it? That is where data science and analytics has a role.”
Inalytics did some due diligence for Brunel Pension Partnership when it was being set up, and analysed nearly 400 RFPs.
“There are two big risks in the selection process. You start with a huge amount of managers and get down to a sensible number. In the process of whittling down you know that managers that shouldn’t have been rejected are rejected; and managers who shouldn’t have made the cut. do. Data analytics and the analysis process can help reduce the risk of those two things happening, so when you get to the shortlist it’s a high quality.”
Critically, di Mascio stresses that due diligence is a process, not just an outcome.
“We don’t give them the answer, we make sure they ask the right questions and they ask questions the managers may not otherwise want to be asked,” he says. “People think it is about coming to the answer, ultimately it is, but the role of questions is critical as through the questioning process you learn a lot as you go along. What we are doing is using data to help them ask the right questions. Helping them ask the right questions will get to the right answer.”
Identifying skill
While di Mascio is quick to point out that asset owners should also not do due diligence exclusively using data, as belief in the people is paramount, he thinks they are not using the full suite of tools available to them and so not getting the real benefits of it.
What data can do, and in the case of Inalytics’ tools, is analyse every decision the manager makes, including everything they do own and don’t own, and identify what is working and what is not.
But crunching the data is only the first step, curating it and putting it into a framework that an investor can use is just as important.
“This is a critical issue. Our clients aren’t data scientists they’re pension funds making investment decisions, they need to know what to do with the data. For us that is a really important step and we can take complicated concepts and communicate them very simply,” he says.
Di Mascio is adamant that skill still exists in the industry, despite the fact that on average funds managers don’t add value net of fees.
“If you took the average tennis player, you wouldn’t be that bothered to pay to watch them. But the 100 turning up for the Australian Open are highly skilled. It’s the same with funds management just because the average funds manager doesn’t add value net of fees, doesn’t mean there isn’t an elite and we continue to find them.”
The Inalytics database, which only contains managers that are tendering on instruction of the client, has an average outperformance of 200 bps gross of fees.
“People have given up that skill exists but maybe it’s because they haven’t got the tools to find it. That doesn’t mean it doesn’t exist.”
Through 30 years of analysing managers, di Mascio says there are four critical criteria for a successful process.
The first, and most important is research, or the ability to have a research process that investigates good ideas and gets the best of them into the portfolio.
“Research is the conerstone of any investment process. Any allocator doing due diligence on a manager needs to understand what their research process is,” he says. A piece of research on 400 portfolios conducted last year separated those that outperformed from those that underperformed and 82 per cent of the portfolios that outperformed had demonstrable research skills.
The second element is sizing and the ability to back the good ideas with conviction.
“If the big positions are not winning it’s difficult for the smaller ones to make it up,” he says.
The third citeria, as outlined in the much-touted paper Selling fast and buying slow, is that managers are bad sellers.
“They can lose 1 per cent through lazy selling,” he says. “Alpha through the first two criteria can be dissipated through lazy selling.”
And lastly is portfolio turnover, where di Mascio observes positions can get stale and “managers can fall in love with their stocks”.