ESG (Environmental, Social and Governance) is attracting growing investor interest and assets. Three leading practitioners – Sandra Carlisle, Head of Responsible Investment at Newton Capital Management in London; Mary Jane McQuillen, Managing Director, Portfolio Manager and Head of the ESG Investment Program at ClearBridge Investments in New York; and Dawn Wolfe, Director, Responsible Investing at BMO Global Asset Management headquartered in Chicago — explain their firms’ philosophies, processes and methods of engagement. They share their view that social good and financial good are converging.
P&I: There is the perception that most institutional investors are already on board with the idea of ESG. Do you see differences in interest levels between DB plans, other institutional investors such as endowments, family offices and retail investors?
Mary Jane McQuillen:I don’t know if you could say most institutional investors are already on board with ESG, but they are now better positioned to do so and they’ve had discussions with their consultants. I would also note that they are more aware of the ability to integrate ESG factors into the institutional investment process. They are also more aware that in the U.S., the issue of fiduciary duty no longer needs to be a hurdle or a block for them to consider ESG or include ESG factors in their risk mitigation efforts.
However, similar to what I’m sure other panelists would think, in Europe and in other country jurisdictions, the question of fiduciary duty has been historically more accepted. There was a groundbreaking legal report published 10 years ago, with our signatory partners at the United Nations Environment Programme Finance Initiative and the law firm Freshfield Bruckhaus Deringer, and the overall conclusion drawn back then — and re-affirmed today in the latest report released this month — was that it would not be a violation of fiduciary duty to integrate ESG factors into the investment process, as long as the same level of robust due diligence was applied to the investment selection process.
In the U.S., institutional investors on the public pension side have been actively considering, and many have started placing, ESG integrated assets according to their Investment Policy Statement guidelines. Interestingly, private or corporate pensions are a group of institutional investors we haven’t seen as much interaction with — despite the image of corporate responsibility projected by many of these companies. So I think corporate pensions are the next investor focus for discussions.
Additionally, endowments and foundations, with a lot of input from their student bodies and their donors, want to differentiate themselves by having more mission-aligned investments. However, a study conducted three years ago showed that allocations by university endowments in this area were surprisingly low. Given the high visibility of the issue among student populations and the evidence regarding performance — which I hope we will talk about later — university endowments are another potential group of institutional investors to start integrating ESG factors into their investment decisions. What we are already seeing from foundations is that, whereas previously they might have excluded public equities and fixed income from the category of “impact investing,” today they are taking these, their two largest asset allocations, and integrating these assets into an ESG approach.
Sandra Carlisle: Demand is increasingly broad and wide, but it is still largely led by European institutional investors. That’s where the most advanced thinking and new innovative developments are largely coming from, such as impact investing and social investing.
What I’ve been encouraged by is there has been a significant acceleration of interest in and demand for responsible investment across the range of capabilities and asset classes from North America. It explains why we’ve seen the sea change in interest in what we’ve all been doing as professionals for such a long time. There are new and different types of investors — ultra-high net worth, family offices, endowments — who are really seeking to align their values very closely with their investments.
P&I: What are you seeing on the demand front, and where do you think the main sources of future demand will come from?
Dawn Wolfe: Geographically speaking, the demand for responsible investment strategies is growing most rapidly in the U.S. market. Among U.S. institutions, we find that foundations and endowments have higher rates of ESG adoption than corporate plans. However, as responsible investment evolves beyond its historical definition of mission alignment to investment analysis inclusive of ESG drivers, demand from more mainstream asset owners is likely to grow. They understand that a myriad of factors, including environmental, social and corporate governance ones, can impact risk-return profiles and should be integrated into traditional analysis. In the retail space, women and millennials will be important sources of demand. More so than previous generations, millennials think of their investments as a way to express their social and environmental values and believe they can achieve a market rate of return while doing so.
Sandra Carlisle: I have a slightly different take here. If you think about responsible investment in the way that we at Newton think about it, it’s just investment. We look at ESG because it’s financial. If it’s not financial, we don’t look at it. So yes, everything said about growth is all true, but this isn’t something that is specific to certain segments of the market. It is a way of thinking about investment. It is taking a much broader view across issues that are going to affect the profile of the returns that you’re getting from a given asset.
In that context, I think the whole market is going to grow because more and more institutional investors are realizing that these issues, which their managers haven’t traditionally thought about, are actually just investment risk and investment opportunity. That says to me the whole market is an opportunity in addition to these specific pockets of cash that might want to allocate to social finance or positive impact.
P&I: What are your recommendations for the first steps toward implementation for those who are interested in ESG?
Mary Jane McQuillen: For investors who want to get started, there are many solid academic research studies around performance, the materiality question and fiduciary duty. And increasingly, there is more information on product availability, which has been a bit of an obstacle in the past.
To get a sense of different managers and performance and pricing, investors can turn to their institutional consultants or financial advisers, as well as to organizations such as US SIF (The Forum for Sustainable and Responsible Investing). US SIF can provide data on mutual funds and separately managed accounts.
Dawn Wolfe: I would add that it is important to involve the trustees or other fiduciary authorities of an institution in this educational phase if they are serious about implementing an ESG policy. Ultimately, the fiduciaries are responsible for defining the investment beliefs of the organization, and a commitment to responsible investment ideally begins there.
Certainly, we would encourage the fiduciaries to leverage their own staff, and those of their managers and consultants. Once the trustee articulates an investment belief that includes some version of sustainable investing, there is a framework that helps others understand trustee expectations, leading to better outcomes.
P&I: What do you think is more important: E, S or G?
Dawn Wolfe: In general, there is no E, S or G factor that’s going to be material for every company all the time. I think that’s something that people can often get hung up on. E, S and G drivers that are highly material will differ among sectors and companies. The work of The Sustainability Accounting Standards Board (SASB) attempts to address this and is a good resource.
Here is an example: Volkswagen and the installation of devices to cheat on emissions tests. We were going back and forth: Is this an environmental concern or a governance concern? This example shows how interwoven ESG drivers can be. VW built its brand around product quality and environmental leadership, but clearly there were significant business ethics issues that undermine not only the company’s brand but confidence in management overall.
Sandra Carlisle: They’re all important. The key is to understand what matters to each company you’re looking at, and look at that aspect in particular. It’s a question of the risk-return and where the risks are and where the returns are. That will depend on the sector and industry the company is in.
Mary Jane McQuillen: Agreed. At ClearBridge, we don’t really think one is more important than the other; the environmental, social and governance issues are inextricable from all business models. However, our analysts on the fundamental side would weight the E, the S and the G by sector. Here environmental may carry more weight, or in other cases it may be governance.
P&I: Let’s move on to performance, which is one of the most important issues when it comes to ESG. What is the truth about performance?
Sandra Carlisle: We get this question all the time. For starters, it’s really the wrong question. It should be about risk-adjusted returns. Capital markets are remarkably good at valuing something when it happened. They’re not necessarily very good at predicting what things might happen.
My job is to pick the most sustainable companies, companies that are going to look after all shareholders and their families for centuries to come. A better and more challenging question would be to prove ESG doesn’t matter when it comes to performance.
Dawn Wolfe: The bulk of research and our experience demonstrate there is no inherent performance penalty for using these types of drivers in investment decision making. In fact, we see ESG as additive. We think that we should expect at least on-par results with traditional funds. The questions we’re starting to get more as a company are less about, “Do I have to give up performance?” and rather, “Is there an alpha?” If we accept that it is do no harm, how much does it really help? This really gets to what we’ve all been discussing already. As we integrate ESG alongside traditional financial analysis and risk management, the approach is then about taking a broader view of investment opportunities. We think ultimately that can help long-term value.
Mary Jane McQuillen: From our experience and from the volumes of ESG performance studies, it really comes down to the quality and the skill and the experience of the management teams. As with any investment discipline, you can have varying performance if an ESG approach is not implemented properly. Sometimes it happens because the practitioner is not as skilled, and so the performance may reflect this inexperience; those of us on this round table have had decades of experience.
You want to get a sense of how long the managers have been involved in ESG investing and whether or not they can continue to be consistent and if their process is consistent. At ClearBridge, we have been able to deliver competitive risk-adjusted performance for one-, three-, five- and 10-year periods.
P&I: Are there specific market cycles or monetary policy regimes that favor ESG performance?
Mary Jane McQuillen: There’s often a perception that ESG does better in bearish markets. There’s also a perception that when it’s a very volatile market or a recessionary environment, that ESG is very good for protection on the downside.
Overall, there are different schools of thought about whether ESG can perform better in different stages of the cycle or under specific monetary policy regimes, but I think that ESG can endure and will do well regardless of the cycles and perceptions.
Dawn Wolfe: Market conditions and the approach to using material ESG factors in the investment process are important considerations. There is research suggesting that in periods of limited risk appetite, a “flight to quality” may benefit companies with strong ESG performance and that strong ESG performance can be an uncorrelated quality metric. But I agree with Mary Jane; ESG can endure regardless of the cycle when you think about it like we do, which is enhancing long-term value by considering the broadest set of risks and opportunities.
Sandra Carlisle: If you’re talking about ethical exclusion, then, by definition, eliminating sectors from your portfolio is going to lead to a lack of diversification and potential concentration risk. Certain stages of the cycle may exacerbate this risk, which you could then see reflected in performance.
If you’re investing across the whole market, and you are looking to make the best risk-adjusted return by buying the best companies bottom-up, then there’s no reason why you cannot be outperforming regardless of what the cycle throws at you. Your job is to achieve the best risk-adjusted return for your clients.
You can also face shifts in the policy and regulatory landscape as well as systemic risks like the global financial crisis or climate change that have the ability to create massive sector and technology disruption. You need to be mindful of these big system shifts and to integrate them into your investment process to protect your assets. With ESG, you should be able to create value around these shifts.
P&I: Drilling down a bit deeper, going from financial topics to an almost philosophical one, which is more important: social good or financial good?
Sandra Carlisle: There is no reason why they cannot be the same thing. If my job is to deliver to my institutional investors and their pensioners, or to 401(k) participants, a return that provides a decent income in retirement, the way I’m going to do that is by taking a 30- or 40- or 50-year view and finding sustainable companies.
For me, capitalism is all about using the least amount of resource in the most efficient and careful way possible. The change that we’re seeing in the industry as a whole is that people are beginning to grapple with this issue to understand it. There is no point in having a company go out of business in five years’ time because it’s caused a massive spillage or a disaster when you need to secure a pension fund that’s going to deliver that savings income in 35 years’ time. So, I don’t think social good versus financial good is either/or.
P&I: Let’s talk more about each of your firms. Why did the firm first make the move into ESG, and where do you foresee the firm going in this space?
Mary Jane McQuillen: ClearBridge Investments has 50-plus years of experience in managing active equity portfolios. We started our ESG program about 25 years ago. We offer ESG strategies in a variety of style boxes, investing in both U.S. and international securities. For the U.S., we are considered one of the older managers, particularly in the institutional and mainstream space.
At ClearBridge, the CEO, the co-CIOs and the head of research have given the directive in terms of ESG research and investment. We believe that it is more effective to have ESG integration as a fundamental process throughout the entire platform as opposed to having the ESG team or ESG research as a separate area. We believe that the way the firm is structured can make or break your ability to be able to thrive and grow in this space.
Dawn Wolfe: BMO Global Asset Management has over 30 years of experience in responsible investment. We launched the U.K.’s first ethical strategy in 1984, in 2000 launched a shareholder engagement service, and in 2006 we became a founding member of the UNPRI (the United Nations-supported Principles for Responsible Investing initiative). Today, we act from our organizational belief that ESG can influence company performance and should be standard practice in analyzing long-term value of the business. We’re committed to maintaining our leadership position in Europe and leveraging that experience to advance responsible investment throughout our global operations.
Sandra Carlisle: Newton Capital Management is a London-based active equity and fixed-income manager, so pretty traditional. We have over $68 billion in Assets Under Management (AUM). We are one of the independent investment boutiques of the Bank of New York Mellon (BK) group. We’ve been responsible investors since the business was founded in 1978 because we think ESG is just part of investing. We don’t believe in this non-financial/financial issue at all. ESG is just what we do because we think it helps us make better-informed investment decisions on behalf of our clients.
Also, that said, about 9% of the book of business is ethical, we are a top five charity investor in the U.K., and we run a variety of screened ethical funds. While we do ethical screening on certain funds, we also integrate ESG across everything, including the screened funds. I think our next steps would be into social finance and positive impact investing.
P&I: What does each of you do in practice to determine what a company looks like from an ESG point of view?
Dawn Wolfe: For BMO Global Asset Management, the exact application of our practices differs from group to group in order to preserve portfolio manager flexibility, but our aim is always the same, which is to establish an ESG view for each particular company because it can enhance the quality of investment decisions.
We do multiple site visits every year and communicate regularly with management and board members. We’ve also developed a proprietary ESG Risk Tool that blends data from third-party providers with our own engagement and voting data. Our Governance and Sustainable Investment team provides this tool to our equity and fixed-income portfolio managers, so they can incorporate this knowledge into their investment process. Just to give one example, our disciplined equity team based in the U.S. recently enhanced its own investment process to formally include and evaluate ESG criteria as part of its investment process. They consider the portfolio’s overall exposure to environmental, social and governance risk and monitor it regularly; it’s integrated into what they do every day.
Mary Jane McQuillen: From an investment perspective, we don’t necessarily see ESG as a separate step or an add-on. We see it as part of the fundamental research discovery process.
At ClearBridge, we have ESG implemented throughout our fundamental platform. All of our sector analysts on the fundamental team will conduct their primary research on ESG factors, as material for their sector responsibility and for the companies under coverage.
The analysts themselves are formally responsible for understanding the ESG issues related to their companies, and their incentive compensation includes their ESG research performance. To us, this makes the most sense because they are financially responsible for those companies in terms of coverage and recommendation. In terms of how to identify or confirm our ESG conviction, the analysts are asked to assign a proprietary ESG rating to each company in our portfolios. They will not only conduct their own ESG research, but they will also do active engagement and meet with management face-to-face.
Our proprietary ratings go from A, AA, AAA. The analyst has full discretion over the rating. Every company research note must include the ESG rating with all the other financial metrics. You could say that the ESG rating should already be built into the investment thesis and conviction level, but we like to see it separately to monitor the “impact” by the company.
Sandra Carlisle: We’ve got a very simple business model at Newton. You’re either a portfolio manager or you’re an investment research analyst. The responsible investment team consists of investment research analysts, and we are the ESG experts. In practice, one of our global sector analysts cannot make a recommendation for the research list unless an ESG quality review is done for that company.
As soon as the analyst has reached the point of thinking about an investment idea and is planning to do any serious research on it, the analyst has got to come to us and request that we do an ESG quality review. It is all proprietary and bottom up. It’s looking at source materials from companies. It’s looking at third-party research across a whole range of different things.
We are not making the investment decision, because we’re not the fund managers. Our job is to make sure that we correctly assess the ESG risk for a given level of return in the company that’s under consideration. We’re literally looking at every single company on its individual merits. It’s a very, very simple process, but it’s wholly integrated into the investment decision-making, and it’s consistent with being a very active global equity manager. We’d rather not invest in something than invest in it and then have to work our way out of a problem. We aim to assess the company at the outset before we commit capital to it.
P&I: What is the real impact of ESG? To be more specific, how does your firm engage with companies and work with them in terms of improving ESG factors?
Sandra Carlisle: All investment has impact. You can choose to have a positive impact in terms of sustainable businesses that are going to be around for the long term or not. That comes back to the risk-adjusted returns.
The way we do engagement relates to our research process where we’re assessing all of the companies. Clearly you’re going to become engaged in companies where you are invested and you see a certain amount of risk, yet with attractive returns. You can mitigate that risk, improve the returns, protect your position as a minority shareholder through active engagement.
That’s where we would spend the time engaging, rolling up our sleeves and having those one-to-one meetings, whether that’s at the board level with executive management or with specialists lower in the food chain. And part of engagement is active proxy voting. You can do both, you can do one or you can do the other, but you should certainly be voting actively if you’re an active manager.
Dawn Wolfe: We’ve been formally engaging with management at global companies since 2000 about the environmental, social and governance drivers that impact the business. We have an annual process to identify the companies we will focus on for the year ahead in terms of engagement. We select companies for engagement where we have the broadest exposure and where the E, S or G risks are most material. That’s our starting point.
We also do multi-year engagements. We think achieving real positive change requires much more than an overnight engagement. One thing that really differentiates our ESG team is its incredible breadth of geographic and professional experience. We speak a dozen languages and come from a variety of professional fields. We meet directly with management and boards of directors and can speak knowledgeably to professionals in a variety of different sectors. This enhances the quality of engagement we’re able to do.
We also track our engagement, and we put the results out to our clients. It’s a credit to this team that in the first quarter of this year alone, they engaged over 240 companies in 29 different countries.
Mary Jane McQuillen: At ClearBridge, we take fairly concentrated positions in a number of holdings. We’re typically a top 10 or top 20 shareholder of the stocks that we’re investing in. That has allowed us to have a high level of corporate access, and we can meet with management regularly. The sector analysts lead most of the engagements, but the PMs can conduct the engagement as well. What we want to see from the engagement is where the companies currently stand in terms of their sustainability approach, but also how their approach fits from the shareowner’s perspective and whether it makes sense as a fiduciary on behalf of our clients.
The engagements that we conduct are on a regular basis and over many years. Each year, as a long-term investor, we’ll go back and check in with company management on their progress on some of the targets that they set or new beneficial innovations that they have achieved. But we highly encourage them on any of the company-specific areas that our analysts have identified as being very important long-term issues for them. As we noted earlier with the E, the S and the G, a number of the drivers for long-term sustainability can vary based on the company.
This type of engagement and impact measurement, as a listed equity manager, allows us to continue to monitor the progress and to speak to the companies. We’ve seen a lot of impact, which is reflected in our ratings: If a company had an A rating before and now it’s AAA, we know the company has made progress. Similarly, we also are active proxy voters. That’s important too.
P&I: Where are the opportunities? This goes beyond not just where you think the market will be in 10 years, but rather how do you think the opportunities will manifest themselves for you and your clients?
Sandra Carlisle: The opportunity for us as a global active manager is being good at what we do and making sure that we are on the right side of risk-return using this integrated ESG approach. That’s across the whole portfolio. I think the future opportunity, and where the market is going to grow and develop over the next decade and beyond, comes back to the point that all investment has impact. We’ve come from ethical screening, which was started up in the ’70s and which was about taking stuff out of your portfolio that didn’t align with your mission, and we’re now in a world of integrated ESG.
There is a spectrum of how integrated people are, but the deeper realization is that this is just risk-adjusted return. And then I think there is an emerging realization that you can actually have financial return and positive social or environmental return that you can measure and quantify. In addition to traditional sources of growth, which will continue, this is where I see the market shifting to and future growth coming from.
Mary Jane McQuillen: We think that the future in terms of opportunity is really about the analysis and about the impact. Our CEO has set the directive that we’re a $120 billion firm and we are conducting ESG research across the platform for the majority of investments right now. Many of our clients have not explicitly asked us to do this, and they may not even be aware that we’re currently doing this for the equity portfolios, but our senior management believes that this is the future of investing. Investors will expect a higher level of inclusion and rigor with regard to societal issues that will affect the investment opportunities.
On the impact side, the future really does have a lot of implications and unknowns with regard to resources, with regard to the environment, as well as the labor and people factors. How are we going to feed everyone? How are we going to deal with water and resource scarcity? These questions are increasingly a part of our meaningful discussions for the investments that we own, and that’s where we think the impact really needs to be addressed and emphasized.
Dawn Wolfe: In the future, this idea that business cannot exist and really thrive to its full potential completely separate from society will continue to gain traction. And it should. Business relies on society and the environment. Drought threatens society and business. Extreme income inequality threatens society and business. There is also opportunity for business to address these societal challenges.
It hearkens back to our earlier discussions about growth in demand and what the next generation of asset owners thinks about the impact of their investments. In terms of the social good versus financial good, in the very long-term you can’t have one without the other.