Executive summary

Investment approach

Culture is one of, if not the, most important element to consider when selecting an external manager. If there is no cultural fit and understanding of ESG factors between an asset owner and a potential manager, there is little fundament to establish a long-term investment relationship.

Questions on investment approach and objectives should shed light on how a manager produces value through ESG insight. Understanding the business and investment philosophy of a prospective manager enables asset owners to ascertain whether such an approach is in line with their own objectives.

An investment policy should reflect an asset owner’s strategy and views on best practice in managing investments, including incorporating ESG factors. A written investment policy should define what ESG means to an investment manager in practical terms. While strong cultures may override weak policies, it is vital that policies are recorded and endorsed by the board and CEO. An assessment of the policy should indicate whether it is compatible with an asset owner’s ESG-related definitions and expectations.

An investment manager may not have the same level of ESG competency across all asset classes. Manager firm-level practices may also not be fully suitable for all asset classes due to style, culture or resources. When selecting an investment manager, asset owners should first look at the firm’s overall ESG alignment, then its capability in a specific asset class, and then choose a suitable investment product.

A firm’s approach to investment governance will depend on its culture, style and size. Certain investment approaches may also require a specific set-up of resources that needs to be observed. An evaluation of a manager’s resources should also extend to the quality and suitability of its external vendors as a regular part of operational due diligence.

Portfolio construction and investment decision making

Services that provide product-level information on portfolio holdings exist, and as part of their reporting to the PRI investment managers answer questions on ESG incorporation processes at the firm level. However, true understanding can only be gained from well-executed dialogue.

Investment managers must ensure that investment processes incorporate ESG analysis, and that such insight is presented to investment decision makers (and that those decision makers are able and empowered to act accordingly). Asset owners should verify that final decision makers use available ESG material and organisational insight in their investment decisions. They should also ask prospective managers to support any claims with evidence and real examples.

Investments always have real economy impacts that can be positive and/or negative (for example, they may increase or decrease pollution levels, generate corporate and income taxes, support employment or create discrimination) and are intertwined with long-term prosperity. Asset owners that limit analysis to purely risk and return are missing a crucial element in their portfolio’s contribution to end beneficiaries and society at large. Clarity on real economy impact expectations during the selection phase will help to align interests for a productive long-term commercial relationship. Asset owners must also be clear about what risk means to them at each level of the investment process, and how it can vary across the portfolio.

In portfolio construction, it is not just a question of what goes in, but how much goes in. Parameters like tracking error are important as they directly influence choice of investments, but may not be critical.

Thematic and screening approaches select investments in securities that fit into certain criteria and play increasingly important roles in asset allocation considerations. Asset owners should pay close attention to the methodology, rules and accuracy of chosen screens during the selection process.

One way to ascertain the effectiveness of an investment manager’s integration approach is to consider the price of an investment firstly with and then without ESG factors accounted for. Activities portrayed as “integration” often merely amount to simple screening, whereas integration done well is a powerful method of fundamental analysis.

Asset owners that wish to include impact investments in their portfolios should seek to understand how their managers define impact and how they seek to measure such impact. One problem facing the industry is the branding of certain funds as impact investments without a clear link to end results. It is therefore vital that asset owners help to maintain the integrity of the market by choosing products and funds that genuinely deliver positive impacts.

Engagement and voting

It is often the case that a single asset owner or manager represents a very small part of a company’s overall capital. A group of investors of the same standing will therefore tend to have a stronger chance of engaging successfully than one single voice. Collaborating with peers also facilitates the dissemination of best practices across the industry.

The process an investment manager uses to engage, as well as its perceptions of engagement, should always be assessed. It is also important to understand the semantics around engagement and voting practices, as some managers may promote pure voting activities as engagement. Engagement activities can directly impact financial performance.

Asset owners should ask for examples of how a manager’s engagement approach is structured. Identifying the individuals responsible and understanding the related processes is a good first step, with ascertaining how those individuals interact with investment decision makers a good second step.

It is also important to find out whether engagements are initiated across all of the manager’s assets. If the manager outsources engagement to a third party, asset owners should assess the terms of the arrangement and the sustainability of the relationship. Asset owners should have the same fundamental perspective on engagement regardless of whether an active or passive strategy is in question.

When engaging through service providers, asset owners should ideally define topics to raise, as well as companies to target and objectives to achieve (this may be done via a policy or as a more hands-on, one-off exercise). Asset owners should participate in the engagements they care most about and establish during the selection and appointment process how such arrangements will work.

During the selection process, asset owners should understand the voting process and assess the quality and suitability of the execution of these processes, as well as any professional parties involved. From a selection perspective, asset owners need to make sure the mechanistic aspects of the voting chain function properly, that quality service providers are obtained and that votes reflect their target(s).

Some investment managers lend equity and bonds to boost their portfolio returns. If those securities are not recalled in time to exercise voting, the borrower is entitled to vote them. Negative publicity might cause controversial votes in stocks with concentrated ownership. Similarly, selecting a product that provides synthetic exposure to a stock or an index through a derivative might not come with voting rights.

Reporting

The selection process should consider the ongoing reporting from the manager to the asset owner and satisfy the latter’s internal investment-related information requirements, as well as be able to serve their own reporting to stakeholders.