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Nurturing ESG

Written by Lynn Strongin Dodds
October 2011

Lynn Strongin Dodds explains how ESG frameworks are evolving within European pension funds' investment strategies

Enthusiasm for integrating an environmental, social and governance (ESG) framework into the investment process waned in the wake of the financial crisis. Investors were more focused on the burgeoning funding gaps but disasters such as the BP Deep Water Horizon put ESG back on the institutional map. The priority levels may vary but there is growing recognition that this could be a valuable analytical tool.

"It's a mixed picture," notes MSCI special adviser and Towers Watson global head of investment content Roger Urwin. "The global financial crisis didn't push ESG off the page but it did move it sideways. There is increased interest and in many cases ESG issues are considered important but they are not always labelled as urgent."

Robeco chief investment officer Peter Ferket agrees, adding: "While there has been a steady recognition, it differs depending on the country. For example, pension funds in the Nordics, Netherlands and France put a stronger emphasis on responsible investing than other countries, while the US in general lags behind Europe."

One of the main hurdles is the definition. "This is an industry that everyone defines differently," says Stoxx global head of product development Konrad Sippel. "That is because there hasn't been clear standards around what it actually means, which factors and data should be used. Everyone has a different view."

Wrapped under the banner of responsible investing, the sector, as with many, is packed with jargon and acronyms that are often used interchangeably. For example, there is socially responsible investing (SRI) which may incorporate ESG issues as well as other criteria more closely linked to a values or ethical-based approach. However, few institutions have shifted assets into specialist ESG strategies but instead have adopted wider remits. This includes implementing ESG overlays which sit alongside the nitty gritty financial analysis such as capital expenditure, cash flows,competitive standing, credit risks as well as the strength of the management team.

An ESG analysis also looks at the quality of those at the helm but also evaluates a company's environmental performance, regulatory adherence, corporate governance structures, accountability to share holders, treatment of employees and support of communities. It also covers expanding proxy voting policies and becoming more engaged with management if there is a concern.

"Growth in ethical investing has remained lacklustre, although we have seen a resurgence in countries such as the Nordics where pension funds are excluding companies
that manufacture cluster bombs, for example" says F&C investment specialist, governance & sustainable Investment (GSI) Sandra Carlisle. "Where we see faster growth is in pension funds integrating ESG criteria into their investment process and analysis. Overall institutions are focusing much more on risk and using an ESG overlay can help identify what those risks may be."

Aviva Investors head of ESG sustainable and socially responsible investment Peter Michaelis adds: "Every time you have a BP event or News Corp type of event, the argument gets stronger for integrating ESG into your mainstream investment analysis. However, it is not just about identifying risks but also secular growth opportunities. For example, we invest in Johnson Matthey because of the strong demand from China which is trying to cut its pollution levels for its catalytic converters as well as pharmaceutical companies such as Roche and Novatris which manufacture vaccines used in both the developed and emerging markets."

According to the latest figures available from the Social Investment Forum Foundation, in the US, sustainable and socially responsible investing assets - broadly defined as investments that integrate ESG factors, involve the filing of shareholder resolutions or have a mission of community investing - grew 13.3 per cent to $3.07 trillion in the three years ended 31 December 2009.

This paled in comparison to Europe where such assets jumped 85 per cent to €5 trillion ($6.5 trillion) from €2.7 trillion in the two years ended 31 December 2009. Asia was trailing far behind with $20 billion in sustainable assets, although this is expected to skyrocket to $4 trillion over the next four years, according to a 2010 study conducted by Vontobel Holding.

This is still a drop in the proverbial bucket to worldwide AUM which were $56.4 trillion in 2010, according to Boston Consulting Group's Global Asset Management 2011: Building on Success.

"I think the level of adoption depends on the sophistication of the trustees and at the moment they still constitute a minority," says Bozena Jankowska, global head of sustainability research at RCM, which is part of Allianz Global Investors. "One of the challenges is that there is perception that companies that are more sustainable do not perform as well. We recently though conduced a study that showed investors could have added 1.6 per cent a year from 2006 to 2010 to their investment returns by allocating to portfolios that invest in companies with above-average ESG ratings."

The study also noted that European companies were ahead of their US counterparts in terms of integrating ESG factors. It revealed that the returns from portfolios of continental firms represented the largest and most consistent spread between best-in-class and worst-in-class companies. Although there is no guarantee that these returns will be replicated in the future, RCM contends that the five year period in the study encompassed wide ranging scenarios including a boom market, unprecedented stock market crash and subsequent rebound.

The most important lesson though is that adopting an ESG lens requires an extended time horizon. As Urwin notes: "Asset managers are caught with the way the fund management industry has developed. It is much more oriented to short-term benchmarks and performance targets and the by-product of this is there is more emphasis on short-term results. A much longer-term perspective is needed to see the impact of ESG analysis on a portfolio."

There also needs to be a greater understanding that if asset managers and owners use an ESG benchmark, it will also produce different returns than traditional market cap weighted ones, according to Sippel. "This is because of the differences in sector weighting. For example, oil companies constitute a high percentage of many mainstream indices while a sustainable index may have different types of energy companies such as solar energy."

This past April, Stoxx launched a series of global ESG indices that include a list of key performance indicators (KPIs) formulated by the Society of Investment Professionals in Germany (DVFA) and The European Federation of Financial Analysts Societies (EFFAS). They are divided into E, S and G categories, and include ‘Programs and Targets to Protect Biodiversity’ in the environment camp, ‘Supply Chain Monitoring System’ under the social label and ‘Policy on Bribery and Corruption’ within governance.

Market participants believe that ESG will continue to gain momentum. The United Nations Principles of Responsible Investing, which was launched four years ago, has grown to 910 signatories, representing about $29 trillion of combined assets under management. The latest PRI ‘Report on Progress’, which covered over 93 per cent of the investor signatories, showed that 94 per cent of asset managers and 93 per cent of asset owners have implemented a responsible investment policy.
Written by Lynn Strongin Dodds



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