Investment mandates: Embedding ESG factors, improving sustainability outcomes

Once they have completed the policy-setting process, asset owners can use the investment mandate to communicate their expectations for ESG integration across a portfolio. Proceeding to manager selection, appointment and monitoring without addressing ESG factors in mandates is a common – but easily remedied – oversight.

Informed by interviews with asset owners and investment consultants, and data on industry practice, this report outlines common approaches and challenges to incorporating ESG considerations and sustainability outcomes in new or existing investment mandates.

PRI data gathered from a broad and geographically diverse asset owner base reveal that asset owners increasingly incorporate ESG policy expectations into contractual documentation, with investment mandates proving to be an exception. This finding is in line with the higher profile of ESG considerations in the relationship between asset owners and asset managers. Our research shows that this shift is attributable to changes in regulation, increasing interest from beneficiaries, evidence on investment returns and an increasing interest in incorporating sustainability outcomes.

Common approaches

Incorporating ESG into mandate design is a different process for new and existing mandates, according to the interviews undertaken for this report. In both cases, asset owners outlined discrete steps to set expectations, collect data, evaluate performance and review decisions.

Existing mandates

As an asset owner’s responsible investment policy evolves, existing mandates governing the asset owner-manager relationship will need to reflect any new priorities or objectives. Re-drafting the mandate or the investment management agreement (IMA) entirely may be a costly exercise, so existing mandates are often adapted through two key actions:

Updating expectations: Expectations for ESG requirements and sustainability outcomes are formally written into existing documentation.

Ongoing monitoring: Managers report on their ESG performance to the asset owner using various frameworks.

New mandates

Though issued less frequently, new mandates can include expectations around ESG integration and sustainability outcomes. These may be incorporated as mandatory requirements, optional features or performance targets. The steps to integrate ESG factors into new mandates include:

Outlining expectations: Minimum responsible investment expectations or standards are set out. Expectations might include certain practices or reporting requirements.

Data collection: Qualitative and quantitative information about managers’ ESG practices is gathered.

Manager analysis: The selection process includes building a roster of potential asset manager candidates that offer strategies aligned with the asset owner’s mandate.

For both approaches, continuous review and evaluation of practices allow asset owners to assess whether an investment manager meets the requirements laid out in the mandate and inform future mandate design.

Industry evidence^[1]  shows that asset owners’ and beneficiaries’ interest in seeking sustainability outcomes has been growing. To align sustainability outcomes with investment mandates, asset owners are increasingly focusing on the UN Sustainable Development Goals (SDGs), on setting targets, and on outcomes.

Challenges

Research for this report highlighted a range of challenges asset owners face when integrating ESG risks and sustainability outcomes into mandates:

• ESG performance and risk attribution
• Consistency with fiduciary duty
• Transparency
• Sufficient length of investment manager track record
• Limits posed by pooled or co-mingled funds
• Benchmark selection
• Insufficient educational collateral 

Next steps

In light of this research and discussions with PRI’s Asset Owner Technical Advisory Committee, two practical next steps emerged to address some of the reported challenges:

1. Encourage and facilitate alignment of approaches to developing investment mandates: Integrating ESG considerations in mandate design remains an ad hoc and potentially time-consuming process. Enabling and facilitating the development of standard elements to be incorporated within mandate design should increase uptake by asset managers. PRI’s report on manager appointment  outlines topics that might be covered within future mandate design.
2. Promote awareness among key stakeholders: Not all asset owners will have the leverage needed to persuade asset managers to implement ESG expectations and sustainability outcomes within investment mandates. Coordination among asset owners to set minimum ESG integration and sustainability outcome expectations could help asset managers develop the relevant competencies and meet asset owner expectations.

About this paper

This report explores to what extent asset owners consider ESG factors when developing and designing investment mandates. It highlights current market practices and barriers to incorporating ESG factors in mandate design and adds to the PRI’s existing work on behalf of asset owners – especially recent guidance on the selection, appointment  and monitoring  of asset managers.

The report will be of particular interest to trustees and those with responsibility for governance of asset pools in public and corporate pension schemes, endowments, trusts and family offices. The report will also be relevant to both asset owners already employing ESG-themed strategies and those newer to responsible investment approaches. The information presented here has been informed by interviews with 15 asset owners and consultants from North America, Europe and Australasia who kindly shared their approaches to integrating ESG in their investment mandates. Though each interviewee comes from a specific regional context, the report is intended to be of value in any geographic region (please see Acknowledgements for a list of participants and Appendix for the questionnaire).

The interviews were conducted in Spring 2021. The report’s findings and commentary also rely on indicative information gathered from signatories through three webinars on manager selection, appointment and monitoring hosted by the PRI. This report was compiled by Wilshire, Sustfin and PRI between April and June 2021. The recommendations are those of the PRI; they should not be interpreted as representing views of the contributors or individual PRI signatories.

The five modules of the PRI asset owner programme are designed to reflect five steps in the asset owner decision process (see Figure 1). The review undertaken for this report has shown that asset owners tend to jump straight from incorporating ESG in their investment policies (Module 1) to assessing the quality of ESG integration during investment manager selection, appointment and monitoring (Modules 3, 4 and 5). This report addresses the missing step, integrating ESG in investment mandate design (Module 2).

Figure 1: The PRI asset owner programme. Source: PRI

Market overview

Evidence gathered from our signatories through the PRI Leaders’ Group and Reporting Framework shows that incorporating ESG-related policies and practices in the selection of asset managers is now widespread. A large majority of signatories include an assessment of culture, ESG policy, training and capacity, exclusions requirements and governance structures in the selection of investment managers.^[2]   In addition, including ESG policy expectations in contractual documentation, such as legal agreements, has now been undertaken by an increasing number of asset owner signatories on all or a majority of their assets.^[3]

Industry data also show that a sizeable minority of signatories are now comfortable tracking positive and negative sustainability outcomes of their activities on all or a majority  of their assets under management (AUM).^[4]

However incorporation of ESG factors into investment mandates has lagged other responsible investment practices. To address this gap, the PRI commissioned research on leading practices among asset owner signatories who are incorporating ESG considerations into their relationships with asset managers, including through investment mandates. The findings mirror practices identified in earlier PRI research (see Figure 2). In response to increasing interest in sustainability outcomes, PRI’s recent framework on sustainability outcomes  articulates the need for asset managers to assess negative and positive sustainability outcomes.

Figure 2: Range of approaches

CONSIDERING ESG ISSUES WHEN BUILDING A PORTFOLIO (known as: ESG incorporation)			IMPROVING ESG PRACTICES, OUTCOMES AND DISCLOSURE (known as: active ownership or stewardship)
ESG issues can be incorporated into existing portfolio construction practices using a combination of three approaches: integration, screening and thematic.			Investors can encourage the companies they are already invested in to improve their ESG risk management or develop more sustainable business practices.
Integration	Screening	Thematic	Engagement	Voting
Explicitly and systematically including ESG issues in investment analysis and decisions, to better manage risks and improve returns.	Applying filters to lists of potential investments to rule companies in or out of contention for investment, based on an investor’s preferences, values or ethics.	Seeking to combine attractive riskreturn profiles with an intention to contribute to a specific environmental or social outcome. Includes impact investing.	Interactions between an investor and current or potential investees/ issuers, in order to: improve practice on an ESG issue, change a sustainability outcome in the real world or improve public disclosure. Engagement can also be with non-issuers, such as policy makers or standard setters.	Exercise voting rights on management/shareholder resolutions (and submitting resolutions), to formally express approval (or disapproval) on relevant matters.
Sustainability Outcomes
Shaping outcomes in line with planetary goals and thresholds such as the UN Sustainable Development Goals and the Paris Agreement

Whichever approach is followed, the responsible investment policy or statement is the vehicle for framing the relationship between an asset owner and asset manager. As part of the Reporting Framework, the PRI has collected more than 1,500 responsible investment policy statements from signatories.

A review of policies in the PRI Responsible Investment Policy Database  found key features that are relevant to the design of investment mandates. For instance, many large and small asset owners have started to incorporate frameworks such as the SDGs and the UN Global Compact within their responsible investment policies. While these policies tend to outline intent rather than detailed processes, some leading asset owners set clear expectations of third-party managers and explain how these expectations are handled. Some describe how these policies influence asset allocation, with links to the SDGs and the Paris Agreement clearly articulated. Many now cover impact reporting, interaction with consumers, commitments to greater levels of transparency and meeting challenges such as net-zero commitments or Paris-aligned portfolios.

Drivers for integrating ESG into mandates 

Our research highlighted four factors that are driving increased incorporation of ESG considerations in the relationship between asset owners and asset managers. These include regulation, beneficiaries, investment returns and sustainability outcomes.

1. Regulation

The recent rapid growth^[5] of legislation governing responsible investment practices is being driven by international bodies, national governments and smaller public jurisdictions. For example, the state of Illinois has adopted a far-reaching approach to regulation relating to the management of public funds.

Illinois Sustainable Investing Act

2. Beneficiaries

Beneficiaries are also increasingly interested in the actual and potential impact of individual savings – whether in pooled or separate accounts. This topic is covered extensively in PRI’s recent reporting on beneficiaries’ interests. Regulation plays a role here as well, with EU fiduciary duty amendments and stewardship codes gaining notice among beneficiaries. Other drivers include:

• Growing beneficiary demand: Asset owners and asset managers have experienced increased levels of proactive requests and have been targeted by campaigns such as Make My Money Matter.
• Rewards of alignment: Understanding and aligning with beneficiaries’ preferences can generate benefits, such as increased pension contribution rates.
• Social media and digital tools: Social media platforms enable campaigners to co-ordinate action and asset owners/asset managers to collate feedback and engage with beneficiaries.

3. Investment returns

Asset allocation is an important component of investment mandate design and is widely considered to be a critical driver of investment performance. Anecdotal evidence from signatories  and selected data from the Reporting Framework suggest that asset allocators are increasingly reviewing their approaches to incorporating ESG factors. Climate-related risks and opportunities are of particular concern as investors seek to improve risk-adjusted returns across multi-asset portfolios. The PRI’s discussion paper Embedding ESG issues into strategic asset allocation frameworks  covers a range of approaches that asset managers and asset owners have developed to incorporate ESG factors into strategic asset allocation (SAA). The importance of global systemic issues – such as climate, governance and human rights – to portfolio returns justifies investor engagement through PRI’s Active Ownership 2.0.

4. Sustainability outcomes

Issues such as human rights, climate change and inequality influence the world in which beneficiaries live and the long-term performance of economies and investors’ portfolios. The investment decisions investors make and how they use their voice as shareholders can have positive or negative outcomes for these issues.

Responsible investment policies incorporating sustainability outcomes and references to global frameworks, such as the SDGs and Paris Agreement, are becoming more widespread. For more than half of the PRI signatories who responded, identifying new investment opportunities and minimising negative sustainability outcomes are the primary drivers for incorporating consideration of sustainability outcomes.

An investor focus on sustainability outcomes brings with it many potential advantages. As outlined in PRI’s recent paper  on the SDGs, these include:

• identifying new investment opportunities;
• preparing for legal and regulatory developments;
• protecting reputation and license to operate;
• meeting commitments to clients and beneficiaries – and communicating on progress;
• considering materiality over longer time horizons, including transition risks, tail risks, financial system risks;
• minimising the negative outcomes and increasing the positive outcomes of investments.

Data from recent snapshots on the 2019 Reporting Framework^[6]   show that increasing numbers of signatories reference the SDGs within engagement, investment strategies and proxy voting. This data would seem to indicate asset owners are showing an increased desire – or are under increasing pressure – to consider the broader implications of investment decisions on sustainability outcomes.

Common approaches

Our research on signatory practices shows there are common approaches when developing new investment mandates or when reviewing existing ones.

Figure 3 illustrates steps used in each scenario to manage ESG risks and seek sustainability outcomes. The final step creates a circular process allowing for feedback and review as policies and expectations change.

Figure 3: Common approaches

These approaches will inevitably overlap and interact. For example:

• The design of a new mandate may influence or result in a review of existing mandates or relationships.
• The approach taken may be influenced by the size of AUM. Smaller asset owners may use pooled funds more regularly and have few, if any, new separate mandates.
• Reviews of investment objectives and expected returns may result in changes to asset allocations and the subsequent design of new mandates.
• Managers may be appointed more regularly for pools of assets that are growing than asset pools that have entered into a distribution phase.

Existing mandates 

Based on our interviews, segregated mandates, IMAs and legal documentation often last for more than five years. During this period, an asset owner’s responsible investment policy may evolve and new priorities could emerge, requiring reviews and updates of existing mandates. This process can be implemented in two steps: updating expectations and ongoing monitoring.

Updating expectations

The asset owners and consultants interviewed reported that once IMAs or investment mandates were agreed they were rarely updated. There was a consensus that more frequent reviews would be a healthy and valuable step, but this was accompanied by an acknowledgement that updating expectations may have additional cost implications. Rather than rewriting a legacy IMA or mandate, many asset owners find it more efficient to signal a change in direction by issuing formal ESG guidelines or reporting expectations to the investment manager. Japan’s Government Pension Investment Fund (GPIF) and CalPERS in the US provide two publicly available examples of updating expectations.

GPIF Stewardship Principles CalPERS’ manager expectations

Ongoing monitoring 

Updating expectations is usually accompanied, or pre-dated, by evolving data reporting requirements for ongoing monitoring. Though unusual, some asset owners specify reporting requirements within their IMAs. The PRI Leaders’ Group provides a framework for leading practice in monitoring existing managers.

Our interviews with asset owners produced interesting examples of manager-monitoring practices and reporting at BVK (Germany) and the state of Illinois (US). BVK is Germany’s largest pension fund, managing 12 pension schemes for professionals in a variety of sectors, including physicians, lawyers and artists. It prioritises manager reporting requirements (especially TCFD reporting) when designing mandates so that its external managers contribute to the fund’s own climate analysis. BVK is undertaking a process of classification for each asset class with specific key performance indicators, including, for example, GRESB^[7]  data for direct real estate investments.

The Office of the Illinois State Treasurer requires four documents from investment managers to aid ongoing monitoring: sustainability due diligence questionnaire, including applicable ESG policies; proxy voting policy; diversity, equity and inclusion report; and a proxy voting statistical report. The final item provides a picture of voting patterns by issue, and percentage supported/voted against compared with management’s recommendation.

Once expectations are updated and monitoring is in place for existing mandates, asset owners are able to review and evaluate investment managers. This step is common to existing and new mandates and will be covered in a later section.

New mandates

For most asset owners, new mandates are awarded infrequently, creating fewer opportunities for ESG incorporation than existing mandates. For new mandates, our interviews showed that some asset owners include formal expectations in requests for proposals (RfPs) as well as optional features or targets. These features must reflect the objectives of a responsible investment policy, fiduciary responsibilities and investment objectives. From our interviews we identified three separate steps towards integrating ESG into new investment mandates:

• Outlining expectations
• Data collection
• Manager analysis

Outlining expectations

Our research shows that minimum responsible investment expectations or standards are increasingly commonplace within new investment mandates. These can be based around essential or optional requirements and measured using qualitative and quantitative metrics. The PRI has introduced a set of minimum standards for PRI membership (see Figure 4). These standards provide an example signatories might use to set minimum standards for investment managers.

Figure 4: PRI minimum membership requirements

Figure 5 categorises additional approaches to minimum standards or expectations discussed during the interviews.

Figure 5: Examples of asset owner expectations or minimum standards

Follow best practices		UN PRI signatory UN PRI reporting assessment and score Regional stewardship code signatory
Adopt relevant policies		Responsible investment Sustainability outcomes Proxy voting Climate change
Report on ESG factors		Carbon footprint TCFD report ESG breaches

Anecdotal evidence from the interviews indicated that asset owners employ these standards to require asset managers to show intent and positive impact. For example, New Zealand Super stated “we are looking to move towards requiring all of our relevant investment managers to demonstrate conscious and measurable effort to societal and environmental benefit as a minimum requirement. This is still in its infancy, however we plan to have this rolled out over the next 12 months.”

Data collection

Earlier we shared the PRI Leaders’ Group framework for monitoring existing managers. When selecting new managers, the PRI Leaders’ Group has also developed best practices for data collection and manager analysis.

Manager analysis 

Investment mandates need to be practical and to allow asset owners to select service providers or asset managers able to fulfil mandate requirements. A well-designed investment mandate will support the steps involved in manager analysis and selection outlined in Figure 6. These are some of the key steps undertaken by our interviewees during the selection and analysis of managers.

Figure 6: Manager analysis

For new mandates this multi-year approach enables those involved in the selection process to identify a pipeline of asset managers that would constitute a high conviction list of candidates. These firms would offer strategies that are aligned with the asset owner’s responsible investment policies. How these approaches might differ between pooled and segregated mandates is discussed below.

Review and evaluation 

Whether seeking new managers or revisiting terms with existing managers, review and evaluation is an important component of the asset owner-manager relationship. It is a process that reflects the dynamic relationship between an investment manager and asset owner – developing over time and subject to periodic reassessment.

This ongoing process enables asset owners to review the extent to which the investment manager meets the requirements laid out in the mandate and legal documentation. Some of the interviewees described a formal manager evaluation framework that categorised managers into different groups depending on policies and processes. These characteristics are covered in PRI’s guide on manager selection, which outlines leading practices among asset managers (see Figure 7).

Figure 7: Leaders’ Group core attributes for investment managers

GPIF offers an example of a process that attempts to evaluate and identify leading asset managers.

Figure 8: GPIF’s approach to stewardship evaluation*

*Source: GPIF Stewardship Activities Report 2020-2021

The relationship between an investment manager and asset owner inevitably develops over time and is subject to periodic review and reassessment. Based on feedback gathered during interviews, we identified two broad metrics used by asset owners to assess investment managers:

• Evaluation: Measures the success against expectations laid out in a mandate.
• Conviction: Reflects the asset owner’s faith in the manager’s ability to deliver against expectations in the future.

Putting these metrics into a framework can help asset owners compare asset managers and assess their ability to successfully fulfil an investment mandate (see Figure 9). The resulting assessment might enable asset owners to decide the appropriate course of action to take with specific managers. For example, an asset owner might engage with an asset manager that has a low ESG evaluation if the asset owner also has a high conviction in the manager.

Figure 9: Review framework – evaluation/conviction matrix

Sustainability outcomes 

The steps above can help to embed responsible investment criteria into mandate development and the manager selection, appointment and monitoring process. Our interviews showed asset managers are at various points on this journey. To be able to assess sustainability outcomes, some have stepped back to take a more holistic view of the process. Evidence from the signatories and AUM flows^[9]  shows asset owners and beneficiaries are increasingly interested in sustainability outcomes. Research for this paper confirmed the trend, with investment consultants reporting increased enquiries on how to incorporate sustainability outcomes into investment strategies and mandates. These interviews outlined three types of connected activities asset owners are taking to align sustainability outcomes with investment mandates.

A. Learning and measuring

Asset owners are increasingly interested in how to align mandates with the SDGs and how to measure the impact of portfolio holdings. Asset owners remain in an exploratory phase that involves:

• developing mechanisms to incorporate the SDGs into key performance indicators;
• measuring portfolio positive and negative outcomes;
• comparing over time or against peers. 

Initial steps undertaken by a number of interviewees include portfolio reviews or benchmarking, while others were starting to consider both negative and positive sustainability outcomes.

B. Target setting

Target setting was frequently mentioned in interviews. Regulatory developments, such as the EU’s Sustainable Financial Disclosure Regulations (SFDR), have encouraged reporting on specific issues or performance against targets. Targets relating to climate, such as net zero commitments, were most common and were adapted to reflect different investment strategies or asset classes.

C. Promoting outcomes

Investors seeking a specific sustainability outcome can pursue dual strategies:

• Intentionally allocate capital in ways that help achieve the outcome.
• Engage collaboratively or individually with investees, policy makers and regulators.

The development of mandates to promote a sustainability outcome remains unusual, though some interviewees mentioned integration of the SDGs. Some asset owners argued that investing in private markets was potentially a more meaningful mechanism to improve sustainability outcomes. New York City offers an example of a multi-asset class search for funds and products aligned with UN SDG 13/climate action.

New York City Change Solutions Strategy

Challenges

Our interviews highlighted a range of challenges when integrating ESG risks and sustainability outcomes into the design of investment mandates.

Figure 10: Challenges*

CHALLENGES
ESG performance and risk attribution	ESG investment strategies outlined in a mandate need to be accompanied by performance and risk attribution. This ensures the implications of risk-adjusted returns of a policy or mandate are understood by the asset owner.
Fiduciary considerations	While asset owners have far greater understanding of the financial materiality of ESG issues than a decade ago, they have been hampered by ambiguous regulatory guidance on ESG and fiduciary duty in markets such as the US.
Improved levels of transparency	Building on developments such as the EU SFDR and the CFA ESG Disclosure Standards, clearer guidance around labelling of dedicated ESG mandates is needed to mitigate against green washing.
Sufficient length of track record	Many asset owners require extensive track records as a minimum requirement for new investment mandates. Some asset owners and investment consultants have a 7- or 10-year track record requirement. Many dedicated ESG strategies do not have a sufficient track record to meet these requirements.
Pooled or co-mingled funds offer limited flexibility	Smaller asset owners and those looking to minimise custodial costs may implement mandates through pooled or co-mingled vehicles. These tend to offer limited flexibility for tailoring to an asset owner’s ESG policy. This barrier is most acute in terms of proxy voting execution. Pooled investments may limit the ability of asset owners to utilise proxy voting to implement a responsible investment policy. The PRI has recently published guidelines for principle-based voting on shareholder resolutions.
Benchmark selection	Most asset owners use a broad, traditional market benchmark to compare ESG strategies. This may restrict an investment manager’s ability to structure portfolios to fulfil responsible investment policies. Some asset owners are considering using a secondary ESG benchmark; a few are providing all managers with an ESG benchmark.
Insufficient educational collateral	Trustees and investment staff require further education regarding the costs and benefits of including ESG factors in mandate design.

 * For more information on fiduciary duty and the regulatory environment, see the following PRI publications: A legal framework for impact and Fiduciary duty in the 21st century final report. Also, from Morgan Lewis: The Regulatory Overlay on ESG Investing. For more information on ESG factors in voting, see the PRI’s Making voting count: principle-based voting on shareholder resolutions.

Next steps

This report maps out some of the common approaches, challenges and solutions for asset owners seeking to integrate responsible investment criteria into investment mandates. Informed by this report and discussions with the PRI’s Asset Owner Technical Committee, we have outlined two possible next steps.

1. Encourage and facilitate alignment of approaches to developing investment mandates

Currently only a small number of asset owners incorporate both formal responsible investment practices and sustainability outcomes in their investment mandates. Often these approaches are ad hoc due to resource constraints and other barriers.

Findings from the interviews and feedback from the advisory committee have identified the need for an entity, body or process to co-ordinate or standardise approaches to the incorporation of ESG into mandate design. This could help both large and small asset owners increase leverage with asset managers to incorporate ESG issues and sustainability outcomes into portfolio construction.

2. Promote awareness among key stakeholders

Asset managers and investment consultants are key stakeholders in incorporating responsible investment policies and practices into investment mandates. A list or statement of expectations or minimum standards could help these stakeholders clearly understand asset owner priorities, while asset owners acting as a consortium could also improve uptake.

If readers have any questions or comments relating to this report, please contact us at [email protected].

Appendix: Asset owner questionnaire – ESG in investment mandate design