With this edition of Institutional Allocator, we bring you this new feature we’ve dubbed Across the Board. In it, IA asks its advisory board members–who collectively represent broad investment industry expertise–to share thoughtful observations on selected industry themes and topics. To Inaugurate the feature, IA recently asked board members to comment on a few basic but still not necessarily widely understood questions around environmental, social and governance (ESG) imperatives in investment decision making.
The following discussion pinpoints some of the complexities of so-called socially responsible investing, from the development of a potentially confusing alphabet soup of terminology, to subjective class definitions, a need to navigate an increasing number of data providers and rating agencies, and weighing non-financial outcomes against investment returns.
Respondents include: Timothy Barron, cio, Segal Marco Advisors, Cameron Black, cio, treasurer, Blue Cross Blue Shield of Arizona; Joe Cullen, cio, Montana State Board of Investments; Chuck Burbridge, executive director, Chicago Teachers’ Pension Fund; Bob Jacksha, cio, New Mexico Educational Retirement Board; Mansco Perry, executive director and cio, Minnesota State Board of Investment; and Carolyn Weiss, cfo, treasurer, New York Community Trust.
IA: How do you define ESG?
If you ask 10 investors to identify the environmental, social and governance issues that are important to them you are likely to have some overlap but not unanimity. It’s a term that opens the door to some interesting conversations.
One of the complexities revolving around ESG and related topics is the fact that there has developed an alphabet soup of terminology that can easily confuse an investor (SRI, SI, II, RI, and ESG). We would define ESG specifically using the language of the Principles for Responsible Investing (PRI)—Responsible investment is an approach to investing that aims to incorporate environmental, social and governance factors into investment decisions, to better manage risk and generate sustainable, long-term returns.
When integrating environmental, social and governance factors into investment analysis and portfolio construction, environmental criteria focus on companies’ ability to manage reputational and operational risks and to capitalize on opportunities created by the shift toward a more sustainable economy; social factors center on diversity, occupational safety, human rights, and more; and governance factors emphasize loyalty to shareholders, board structure, shareholder rights, misconduct and political spending.
ESG investing, impact investing, socially responsible investing, mission investing, and responsible investing are all investment-related topics, but often it can be difficult to understand how these topics might be similar or what their differences may be. It seems important for each of these approaches to add a qualifier or emphasizer to suggest it is different than “investing.” I believe the naming approach suggests that all of these are a segment, type or approach of investing and therefore a sub-set of overall “investing.” For years, investors have been developing sub-categories for investing: style segments, capitalization categories, and ratings or sector classifications, which have each led to further segmentation into sub-sub-categories. The reason for this compartmentalization is to help provide transparency and improve the understanding of risks. However, just because the parts can be better described, doesn’t mean the whole can be better understood.
We do not have an ESG policy, thus no formal definitions for ESG or impact investing, except that we would at least somewhat cover governance with our proxy voting policy for U.S. public equities. Our policies are clear—our mission is to balance the risk and return of our investment portfolio for the financial benefit of our participants. Period.
As an underfunded pension fund, we do not have the luxury of giving up some of the risk/return balance to pursue environmental or social causes. The G [governance] is a different matter. Properly governed companies perform better. Thus, we do pursue prudent governance and have a proxy voting policy to cover that area.
E: [environmental] would include “green” investing such as wind, hydro and solar power and the prohibition of fossil fuel investment. Also, I guess it would include the avoidance of investment in companies or organizations that participate in activities that degrade the environment. We do have investments in wind, solar and hydro power and mitigation banking in our private investment portfolio. I suspect we have some in our public securities portfolio as well (much of our public equities are in indexes and thus we do not do a lot of research on individual companies). If we can find an investment opportunity that first has an attractive risk/return profile and it is environmentally beneficial, we do view the environmental aspect as an additional attraction, but that is secondary to the financial aspects of the opportunity. In addition to the power generation investments, we also invest in organic farming in our agriculture portfolio and have two investments in Conservation Forestry funds.
We do, however, also invest in oil and gas. We are in New Mexico and much of our state economy is dependent on fossil fuels. It would be difficult to prohibit such investments.
So, to the extent that we practice E, it is by inclusive means, that is including some “green” investments in our portfolio rather than through prohibitions of investments like fossil fuels.
S: [social] The definition is a little less clear to me. As I think about it, I don’t really know what it encompasses. I guess it would cover how companies interact with employees, suppliers, competitors and the community at large: do they pay well? have employee friendly policies? deal fairly with suppliers? promote diversity? etc. Are there good educational and employment opportunities available for the populace at large in a region? We don’t impose our standards on our managers, but we do frequently quiz them about diversity when we see a non-diverse team.
G: [governance] Good corporate governance includes proper Board oversight, including having Board members from the outside, proper executive compensation plans, audits, internal controls and observance of shareholder rights (looking at you Facebook!).
ESG is an extension of the balanced score-card concept that suggests that organizations should be evaluated on non-financial criteria. In the public sector, this resulted in the Service Level and Accomplishments reports issued by many units of government. Often, the best units of government were the first adopters of the report. Governments that scored well on the balanced-scorecard criteria were often considered to be the best managed and sustainable units of government. Similarly, with ESG, corporations are being evaluated based on non-financial criteria and those who score well are considered the best managed and sustainable corporations. Recent research suggests that these managers are being rewarded by investors.
I believe ESG is neither an investment sector nor an investment product. I view these three factors as philosophical viewpoints, which investors should advocate as approaches that if adhered to could promote behaviors which have the potential to result in better outcomes. These concepts should be part of the investment decision making process, as they may possess financial relevance.
IA: How do you define Impact investing?
An impact investment targets a specific non-financial outcome as a goal alongside the traditional considerations of return and risk.
Again, here we would look to the expertise of the Global Impact Investing Network (GIIN), which defines II as: Investments made with the intention to generate positive, measurable social and environmental impact alongside a financial return.
Double-bottom-line investing. Being cognizant of social or environmental impact as well as a financial return.
That would be investing to improve the situation of poor or underprivileged individuals. The situation may be a lack of financial resources, educational opportunities, availability of clean water, employment opportunities, etc. We did our first investment in an “impact” fund through TPG’s Rise Fund. We thought this was a unique opportunity because they had been doing this type of investing, and doing it profitably, with their growth funds. We have been an investor in several of those funds. Thus, there was a history of performance that we were comfortable with and found the added “impact” desirable.
Impact investing is designed to achieve a particular outcome beyond the financial ROI or perhaps even in lieu of a financial ROI.
An investment approach where the desired impact may be paramount to the investment return.
IA: Have you seen growth in interest in ESG over the past year? Why?
Yes. The ESG framework is a powerful tool for engaging individuals who are not otherwise finance and investment minded. I sit on the investment committee of a community foundation that has recently created an ESG-oriented investing option for its donor-advised funds. I think this makes perfect sense. Charitably minded investors are also likely to want to express their social views in their investments.
Yes. We attribute growth in interest to four principal influences: 1. Time-since the GFC and generally favorable capital markets make it easier for investors to consider a wide array of factors including ESG; 2. The rise of the millennials as investors who appear, in general, to have an interest in having investment options available to them that are more responsibly focused; 3. Marketing—a plethora of products are now being sold/offered with various ESG screens or processes—availability and sales raise visibility and interest. 4. Data—we now have multiple benchmarks and tools for ESG investors and many data-based studies and analyses that investors can access to understand and gain comfort.
Yes. The next generation of investors are convinced that ESG investing can be done with excellent returns. Or, there is a belief that ESG investing is more important than returns.
I believe interest has grown as demonstrated by the numerous articles and conferences devoting time to the subject. Why? Because long-term investors perceive that ESG can be isolated as a factor to identifying high-reward investments.
Yes. There appears to be significant demand for investments which have some societal benefit as well as providing financial performance. Some pursue because they believe consideration of ESG factors will result in better financial outcomes. Others pursue because of a belief that the factors are essential and are less concerned about the financial impact.
IA: Have you seen growth in interest in Impact Investing over the past year? Why?
Yes. Because now it’s understood that impact and returns aren’t a trade-off. There’ve been plenty of studies showing that doing good isn’t at the price of lower returns.
Yes. But not as much as in ESG. Why? The universe of institutional investors that are drawn to impact investing to accomplish non-financial goals is smaller than that of investors looking to increase financial returns.
Yes. There appears to be increased demand where the proponents desire a specific outcome and the financial performance is irrelevant.
IA: How has the socially responsible investing sector changed over time?
Broadly, we are seeing more ESG options that are truly active and customizable. The first frameworks for ESG investing (and its predecessor SRI) were focused on exclusionary screens. Now, there seems to be no end to the number of managers who are happy to help you express your specific sociopolitical beliefs through your investments.
We are seeing more movement towards full integration as opposed to screening or elimination methodologies. We add that this isn’t a “sector”, but rather is another way to assess information that, even in the parlance of the current administration’s SEC, may have relevance in better understanding what may drive long-term returns for investors. In short, it is difficult to deny that ESG factors may have a material impact upon future earnings and share price and credit quality.
I don’t know the order in which these investment-related terms were introduced, but the terms that were created more recently seem to suggest that the earlier terms were inadequate, while at the same time it was important to brand the new term as distinctive from traditional investing. Years ago, the emphasis was more on excluding certain items, now the emphasis is increasingly on integration, which I see as a positive trend, but not necessarily easier. Based on the volume of recent discussions, maybe the current emphasis will find broader support. I expect we will continue to sub-divide investing into increasingly niche specializations. Although this trend will make it easier to create and market new investment products, I’m unclear if it will make it less problematic to reach our investment objectives.
New sources of data have allowed investors to drive decisions on factors that were previously the subject of speculation and opinion.
Both approaches are derivatives of responsible investing. Responsible investment approaches continue to gain in popularity due to greater awareness.
IA: What’s the most interesting thing about the sector?
ESG is a good branding tool because if you ask someone if they support a healthy environment, a strong social fabric and good corporate governance, of course they are going to say “Yes!” But there are significant subjectivity issues around definitions and implementation. There are also disparate approaches to ESG measurement and reporting. While ESG managers are quick to point to evidence that their approach can translate into higher returns, much of the research I have seen smacks of data mining. I have no problem whatsoever with anyone who wants to allocate their investment portfolio in accordance with a broader set of beliefs, but I think the jury is still out on whether ESG leads to better returns.
If we turn to Impact Investing, we think the opportunity for investors to simultaneously earn an attractive return while helping to change the world for the better in a proactive way has the potential to be a game changer for our future. From clean energy, to potable water, to agriculture, to waste and sanitation management, there are many issues to address if we are going to be able to sustain a livable planet for generations to come. The concept that private capital can play an important role in accomplishing what must be done is both promising and exciting.
There are many ways to begin investing. Pooled investments are a good start and support a learning curve.
Recognition that there is a feedback loop between corporate behavior, quality of life, and investments.
IA: How does your organization invest in address ESG or impact investing in your portfolio?
Before ESG was a part of the investing zeitgeist, we had put restrictions on direct investment in tobacco companies. This was at the direction of our board of directors which was rightly concerned about the optics of a health insurer doing anything to support a product with such indisputably negative health consequences. More recently, we discussed the possibility of implementing a more complete ESG investing framework but have not chosen to pursue that now. Relative to impact investing, we do invest in low-income housing tax credits, not because we have CRA [Community Reinvestment Act] requirements—we don’t—but because affordable housing is a cause we believe in as a company. There is a strong link between affordable housing and economic security generally, and positive health outcomes.
We’re not presently investing in ESG. As an endowment, we feel that we support organizations through our grantmaking and earn investment returns in our portfolio. It’s a different skill set to be able to combine ESG and impact investing knowledge while following a standard investment policy statement. However, we’ve invested our administrative surplus (positive bottom line) in several pooled impact investments. We’ve outsourced the due diligence in a similar way to our private equity investments.
If your institution’s primary or secondary mission is defined beyond an investment return objective, compartmentalizing investments may help refine an investment process to better align with your mission. However, if your mission is best achieved by improving long-term investment returns, then keeping a broader definition of investing will create more opportunities for success, while still allowing you to add value through employing appropriate governance and integrating and evaluating fair pricing for a growing list of multi-dimensional risk exposures. If I chose words to describe my focus it would be fiduciary investing. I believe this describes a balanced emphasis on mission and the broadest opportunity set of investments.
At this stage we are educating ourselves on the opportunity.
We have adopted ESG considerations. They are part of our investment beliefs. We have no position on impact investing.
IA: Do you expect to see more interest in the area going forward?
Based on the marketing dollars that continue to be spent on promoting the many variants of ESG, I would guess we are nowhere near peak ESG.
Yes. We believe that evaluating ESG factors will become just another part of the fabric of investor behavior, where the responsibility of the asset manager or fiduciary is to assess all factors that might be material.
Yes. I believe that research is identifying additional sources of data that will be the subject of analysis and testing to gain an advantage for constituents.
IA: What is your outlook on the sector?
We don’t believe ESG is so much a sector but rather a framework for aligning investment choices with personal or institutional beliefs about how the world should be. I don’t know that we will be talking about ESG specifically 20 years from now, but I would guess as technology and big data continue to advance, we will be provided with even more granular ways to align our financial and philosophical goals. There will always be a desire to do good while doing well.
Very positive. Impact investing is not more or less risky than other investment strategies. Some argue that as soon as an investment decision is constrained, for example, by adding a social or environmental requirement, the financial product will perform worse.
I believe investors will continue to research the opportunities and make modest, at first, investments in ESG.