The challenge for financial institutions is to consider the long-term implications of their investments. Climate change is an important topic, but human rights, labor standards and business ethics also require attention, as society and regulators are increasingly holding companies and financial institutions to account for their contribution to our common future.
The question, therefore, is where to start. A seven-step process can help make decisions on, and succeed in, sustainability investing (SI). The steps are:
1. Defining a purpose
First and foremost, time needs to be spent discussing and assessing the motivations for adopting SI with stakeholders, including clients. Some of the key drivers range from reacting to external pressure to being a full, pro-active believer in the benefits of SI.
Once these motivations are clear, it is a matter of drawing up a policy statement, or incorporating them into a statement of investment beliefs.
2. Setting priorities
A statement of priorities could help identify critical sustainability themes. There are several international codes and frameworks that can be of help, such as the United Nations Global Compact, or the Rio Declaration on Environment and Development.
Alternatively, an investor might prefer to focus on specific issues such as climate change, in this case using the Paris Agreement as a basis for developing a policy. The UN Sustainable Development Goals can also provide substance on how to frame goals and priorities.
It can be challenging to translate purpose and priorities into an investment strategy. The key task is to balance specific sustainability requirements with their impact on risk and return, and to do this over multiple asset classes. Broadly speaking, the three key considerations should be using overlays, adopting themes, and running risk/return analysis. So let’s discuss these in turn.
3. Considering overlays
Generally speaking, applying an overlay across an entire portfolio should not directly affect its performance. There are several overlay solutions within sustainability investing, led by the use of voting for equity holdings, engagement with companies to seek ESG improvement, or the exclusion of companies and countries
Most asset managers employ a voting strategy for their funds and mandates, though policies and practices can differ quite substantially. Engaging with companies can be a powerful tool for change: better control of ESG risks and awareness of opportunities can lead to better financial performance, and have a positive impact on society.
4. Theme implementation
There are several ways to implement a theme, be it climate change or more bespoke issues such as water scarcity or labor standards. One is by avoiding the worst offenders, or integrating the factor into investments: portfolio exposure could be targeted on the specific factor.
The investor could also engage on the specific theme (including voting and submitting shareholder proposals), or finally, invest in companies that provide solutions to the issue.
5. Risk/return analysis
Implementing sustainability characteristics can have an impact on the risk or return expectations for the portfolio. The implications will differ depending on the goal and the instrument used.
The process of setting sustainability objectives, determining a strategy and implementation is very similar to that of a regular investment process. In quantitative investing, the effect of applying sustainability guidelines and themes is easier to quantify using evidence-based research. In fundamental strategies, the ex-ante effect of using ESG criteria might be less easy to calculate.
6. Manager selection and monitoring
Once the initial steps are complete, it should be relatively straightforward to set up guidelines for asset managers. For large investors investing in segregated solutions, sustainability factors can be built into existing mandates if the asset manager has a good understanding and experience of SI. This might be more difficult for investors using pooled vehicles.
In both cases, the first task could be to assess the strength of the current manager(s) in relation to SI. An effective way to promote change would be to engage with them on improving their sustainability profiles. Holding roundtables to share knowledge can also be a powerful tool for change.
7. Integrating and evaluating
As a final step, the chosen objectives should be evaluated once a year, based on the sustainability reports of the managers involved. Ideally, this process should form part of the regular investment cycle to create a truly integrated ESG approach.
To sum up, implementing sustainability investing can take many years, and we therefore believe that investors should dip a toe into the SI water before jumping in. A first step could be to introduce exclusions and engagement, and a second to consider adding some aspects such as carbon footprinting or ESG integration to part of the portfolio.
The outcomes should be evaluated and monitored regularly, and could be embedded in existing structures as an effective way to achieve true integration. As experience in sustainability investing grows, so too will conviction.