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Sustainable Investing Opinion Briefs: May 2019

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May 29, 2019 – According to a paper by Dutch asset manager Rebeco, investment strategies that use exclusion as their primary investment screening “tool, are not sustainable”. As reported in Expert Investor by Joe McGrath, Rebeco’s head of ESG (Masja Zandbergen) addressed the issue of “greenwashing” by further suggests that “investing in” lower quality ESG “companies and engaging with them might be a better way of creating change”. It is also suggested that “more transparent and integrated thinking to determine sustainability” is advisable.  We agree that improved transparency will greatly benefit both asset managers as well as investors by serving to avoid reputational risks and investing disappointments down the road given the confusion that exists around sustainable investing at this time.

May 28, 2019 – Reuters Breakingviews provides a “Breakdown: ESG investing faces sustainability test” by Anthony Currie and Neil Unmack. The article gives a summary of key questions related to the growth of ESG investing. Most notable is their identifying the potential for “risk that ESG scores are manipulated or diluted”. This is seen as a challenge for ESG fund managers, especially in cases where “companies have published information designed to flaunt their virtues” if for no other reason than to pass through manager’s investment selection screens. We agree and see this as another layer of oversight and expertise that managers must adopt if they choose to offer sustainable funds. Further, we see an added risk when managers not only rely on third-party sustainability scoring services, but also depend solely on financial expertise when assessing various ESG factors, subject to the type and nature of the manager’s sustainable investing strategies.

May 23, 2019 – In an article in planadviser by Rebecca Moore summarizing a Natixis study “Investors Want Conclusive ESG Performance Information”, it is stated that the majority (56%) of institutional investors “believe there is alpha to be found” in ESG investing. However, the study also finds that the “lack of track record and difficulty measuring performance” are impedances. That said, 50% of US institutional investors say they have the information they need to make ESG decisions. There is also a concern that ESG “may increase costs to retirement plans” and whether investors will see excess returns when their portfolios are overweight ESG stocks. We believe that such insights on the part of investors have validity and should be evaluated and addressed within the context of a clear understanding of the meaning of ESG and the related strategies that may be employed across eligible portfolios/funds under consideration.

May 17, 2019 – When considering ESG funds, especially those with a developing market tilt, investors are advised in an article in Market Watch (“Better Way to Emerging Markets Virtue”) to recognize that “companies that excel at environmental stewardship … may be lacking when it comes to the ‘S’ and ‘G’ in ESG”. Companies in developing economies, particularly state-run enterprises may overlook shareholders’ interest in and exposure to social and governance factors. As such, there is a possibility that company “profitability and future returns” may be adversely affected. We agree, and believe this highlights the importance of focusing on all aspects of the “ESG equation” with an aim to improve financial performance and mitigate financial risk, even if a portfolio is mandated to cover only narrowly defined sustainability considerations. Further, this broad focus is important with funds investing in both developing and developed economies.

May 13, 2019 – A report from the Defined Contributions Institutional Investment Association, as reported in Pensions & Investments states that “ESG investing is incompatible with fiduciary responsibilities”. It also states that ESG investing is “increasingly independent of moral stances”. However, the report goes on to say that when pension plans add ESG funds the due diligence process “is identical to incorporating ESG principles into investment lineups”. Our view, which has been expressed in recently published articles, is that while there has been an increase in offerings, a combination of issues could continue to restrict uptake, such as uncertainties surrounding the interpretation of fiduciary responsibility rules, legacy socially responsible performance concerns, the possible impact on overall plan administration costs, and the need for education. To these, the following should be added: (1) The trade-offs between adding one or more sustainable investment options and a growing recognition that the simplification of and reduction in the number of investment choices leads to better participants experiences, (2) the challenge of satisfying the values orientation or sustainable investing sentiments of large and diversified participant populations with a single or a selected number of investment options, and (3) the limited number of sustainable fund options available at this time with track records that extend to three-to-five years. Taken together, even as more recent survey results point to some gains, these obstacles will likely continue to restrict progress around the adoption of sustainable investment choices in 401(k) plans.

May 2, 2019 – A survey by LGT Capital finds that investors with longer market investment experience are “more likely … to exclude managers over ESG concerns”. The survey, as reported by CityWire’s Margaryta Kirakosian, “found that 76% of investors with seven or more years of sustainable experience” are “likely to off board managers based on their ESG issues”. Underlying this is the view that “high conviction” managers are “much more likely (69%)” to believe that ESG increases risk-adjusted returns than those with low convictions. While these results may not entirely reflect retail investor behavior, we believe that it could with time and with education. Our view is that interest from retail investors, even as net cash inflows into US mutual funds and ETFs remain modest, is not going to go away.

May 1, 2019 – A white paper dated May 1, 2019 by Randy Bauslaugh and Dr. Hendrik Garz entitled “Pension Fund Investment: Managing Environmental, Social and Governance (ESG) Factor Integration” makes the important case that there is considerable confusion regarding the meaning and implications of ESG factor integration on the one end and, on the other side, responsible investing. Although the paper directly addresses this topic via the prism of the potential professional and reputational implications for Canadian actuarial and other firms that advise pension funds in the exercise of their fiduciary duties, we believe that this topic is also very relevant for asset managers in the US who have adopted ESG integration approaches to investment management and whose investors may be attracted to such strategies without fully understanding the distinction between the two approaches and expected outcomes. This situation could potentially lead to investor disappointments, shareholder redemptions and potential reputational damage to investment management firms that can be mitigated via more explicit and transparent disclosures. We further believe that investment management firms should step up their sustainable investing disclosures by offering greater clarity regarding their strategies, investment decision making, performance attribution, impacts and/or outcomes and, to the extent applicable, engagement and proxy voting.

A major theme of this paper is the distinction between socially responsible, ethical or impact investing (which is referred to herein as SRI), and ESG factor integration. Legislation, regulatory guidance and statements from agencies, such as the United Nations blur these distinctions. The purpose of ESG factor integration from the perspective of a pension fund should not be to stop climate change, improve workplace diversity or end child labor. That is more of what is referred to as SRI investing in this paper. Such results may flow from integrating ESG factors into investment policy, but the purpose of employing ESG factor integration should be to improve financial performance or mitigate financial risk. From a legal perspective, other non-economic goals or aspirations are at best distractions, and at worst departures from proper fiduciary behavior.

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