Asset managers are being forced to re-think their approach to asset selection in order to attract a new generation of institutional and retail investors who expect Environmental, Social and Governance (ESG) factors to be integrated into investment strategies.
Definitions of the parameters of ESG vary significantly (see Figure 1), as do the methods investors are using to integrate ESG into their investment process. We conducted interviews with over 50 industry stakeholders – including portfolio managers, ESG specialists and those engaging in investment stewardship activities – to understand how funds are incorporating ESG considerations into their investment decisions and addressing some of the challenges around data and the growing ESG skills gap.
Figure I: The ESG investment spectrum
Differentiated ESG products: It is no longer enough for managers simply to apply negative screening processes to their portfolios. Asset managers must define what ESG investing means to them (including the relative importance of environmental versus social versus governance factors) and align their investment strategy and portfolio accordingly. Both institutional asset owners and individual investors expect proprietary, differentiated approaches to ESG where portfolio managers are identifying stocks that are best in class relative to specific ESG criteria.
Prioritising the E and the S: The importance of strong governance has long been recognised by investors, but recently we have seen environmental and social factors rising higher on the agenda, with climate change taking centre stage. Investors continue to find S factors the hardest to integrate, partly because it is difficult to define and measure societal impacts, and partly because the importance assigned to particular social indicators varies between cultures, making it difficult to develop a standardised framework for integration. Recent studies showing linkages between strong social performance and positive financial returns have helped to draw attention to the importance of the S, and we expect to see a greater focus on social factors as the quality and consistency of the data improves.
Effective stewardship is critical to success: Asset owners increasingly expect portfolio managers to engage directly with companies on ESG issues, rather than outsourcing engagement activities to a specialist team or third-party provider. They also expect asset managers to be able to demonstrate what they have done to help improve a company’s approach and conduct. While there has been a slew of successful divestment campaigns recently – most notably targeting fossil fuels – we see a growing number of investors choosing to engage rather than divest in order to steer companies onto a more sustainable path.
Leading firms are helping to set the policy agenda: The UK Stewardship Code 2020 is one of many new initiatives raising the bar for investment stewardship standards with a specific focus on tracking outcomes relative to ESG targets. Asset managers have a clear role to play in sharing their insights with policy makers to support the evolution of regulatory frameworks. Firms such as Schroders and Hermes have invested heavily in their stewardship efforts recently, but the personnel and resources dedicated to it across the industry as a whole are still minimal. We expect this to be a key strategic priority for asset managers in the year ahead.
Materiality matters: Not all ESG issues have the same impact; the Sustainability Accounting Standards Board’s (SASB) industry-specific standards look at the most financially material issues to each industry and have become an increasingly popular tool. They identify resource intensity and sustainability impacts as well as an industry’s sustainability innovation potential and are enabling investors to integrate ESG factors more effectively to achieve financial performance. Analysis at this level is becoming an industry standard.
Rising use of AI technologies to manage risk and enhance returns: Asset managers are channelling substantial resources into artificial intelligence (AI) driven tools to process huge volumes of unstructured data and gain a competitive edge. A recent survey found that investment firms using big data and analytics are increasing their revenues 1.5 times faster than the rest of the financial services sector. We see a growing number of LPs using AI-driven tools to keep up with emerging ESG issues that might impact their investments and, in some cases, using real-time data to test portfolio managers’ knowledge. Regrettably, not all investors are testing AI systems as they should; to avoid bias, asset managers must ensure that the methodology behind AI-powered analytics is both transparent and monitored to ensure its integrity.
Firm wide adoption: market leaders are dedicating time and resources to educate their personnel about ESG integration and why it is value-accretive over the long term. While small firms can find it relatively easy to bring about a culture shift that sees ESG factors prioritised, we see larger players finding it more challenging to effect widespread change whist continuing to innovate and market their ESG products to their diverse client base.
Cultivating the right organisational structure
Centralised vs decentralised: There are two principal ways in which investment firms typically incorporate ESG into their organisational structure: the first is a fully integrated and decentralised model, where analysts and portfolio managers are responsible for both traditional company research as well as ESG analysis. The second structure features a dedicated ESG team responsible for conducting specialised research (and, in some cases, developing ESG proprietary screening methodologies) which are then fed into the investment team.
Towards greater integration: In leading boutiques, ESG specialists typically sit within the investment team. We are also starting to see larger asset managers moving to this model to facilitate effective collaboration between ESG specialists and investors. Over time, we expect more funds to adopt a decentralised model where all analysts and portfolio managers are trained in ESG and held responsible for integrating ESG factors into their investment process. In other words, ESG becomes business as usual.
Specialist ESG teams: Arguably, the nascent stage of ESG investing means that many firms require dedicated personnel to drive the ESG agenda forward and keep abreast of evolving data and regulations. Specialist teams range in size from one to twenty full time staff members, depending on the size of the firm and the breadth of their sustainable investment activities. Unsurprisingly, ESG integration works best when supported from the top. Ensuring the ESG function is suitably empowered and reports to the executive board is one way in which firms are facilitating company-wide buy in.
Creating centres of excellence for ESG: The credibility of the ESG and stewardship functions is paramount. The prevalence of greenwashing in investment portfolios has generated significant scepticism of ESG and has slowed progress. The market is still disrupted by too many asset managers that erroneously brand their strategies as ESG without due knowledge or process. The historic prevalence of ESG teams staffed solely with academics specialising in climate change and international development is giving way to integrated teams of specialist investment professionals who can help portfolio managers with returns-based evidence.
Compensation: Rising demand is driving salaries for ESG oriented investment roles above traditional investing roles, particularly among mid-senior level portfolio managers with proven credentials in ESG investment. ESG specialists who sit separately from the investment team generally earn less than their peers doing company analysis within the investment team. Some firms are choosing to incentivise their portfolio managers by aligning a portion of their annual compensation to ESG performance.
A widening ESG skills gap: Competition for skilled ESG analysts will continue to intensify. More firms are investing in specialist external consultants as well as employees from a broader range of backgrounds for their ESG teams, including individuals with proven investment credentials. Currently, demand is particularly high for ESG product specialists.
Upskilling: Asset managers will continue to upskill employees (including senior management and Board directors) as demand for ESG specialists grows. Personnel charged with pushing the ESG agenda forwards internally require specialist knowledge along with exceptional communication and influencing skills.
Growing interest across candidate pools: ESG has become a desirable area of specialism, particularly given the broader decline in most other areas of active asset management. The interest is particularly prevalent among junior investment professionals. To a lesser extent, we have also seen a trend among more seasoned finance professionals seeking advisory and non-executive roles with a responsible investing bias.