There are many different approaches to responsible investing, some approaches are more proactive and pragmatic than others. Multiple approaches could be used within the same managed fund. The underlying considerations across all approaches are environmental, social and governance factors.
Figure 4 gives a simple overview of the fundamental approaches a Fund Manager may pursue.
Figure 4 Fundamental approaches to responsible investing via managed funds
Check the Pulse
Overall Entity
Research IP has witnessed a significant shift in the amount of information provided by Fund Managers on ESG issues in recent years. To help understand the motives and overall credibility of the Fund Manager regarding responsible investment, Research IP seek to answer the following questions about the overall entity:
- How often does the Fund Manager review their responsible investment policy? Who undertakes this review?
- Why has the Fund Manager chosen their responsible investment approach?
- Does the Fund Manager issue any regular reports to demonstrate recent activity with respect to ESG factors in their portfolios?
- Does the Fund Manager have any third-party external assurance from responsible investing organisations? e.g., PRI or RIAA
- Does the Fund Manager’s responsible investment approach apply to all investment products, or specific products? For example:
- Some Fund Managers use a whole of business approach, with ESG teams filtering the list of securities from a corporate perspective which flow through all products.
- Other managers address ESG through a sleeve or product suite, rather than overlay the whole list of available securities meeting ESG requirements.
- Do the qualifications or experience of the investment team help the Fund Manager gain a deeper understanding of ESG issues?
- Does the Fund Manager vote some / all of the proxy votes? Do they ever vote contentiously, i.e. against management and not simply follow one of the proxy advisers like ISS?
Integration
Integration means that factors related to ESG issues are incorporated into the quantitative and qualitative analysis of a company and the industry in which it operates. Corporate engagement and proxy voting is a valuable aspect when used in this approach. ESG integration simply means investment analysis is viewed through a broader lens. Research IP believes integration is the most holistic approach.
Having an “ESG team” in London that the local fund managers “disagree” with is a form of greenwashing.
Research IP seeks to answer the following questions when evaluating a Fund Manager’s approach to ESG integration:
- What is the Fund Manager’s reason for considering ESG issues in their investment process?
- Where in the investment process are ESG factors integrated? E.g., in the initial screening of the investment universe, through research analysts, by the portfolio manager, all of the above?
- What ESG research does the Fund Manager undertake internally versus use of external providers? How does this research affect the construction of the portfolio?
- What examples does the Fund Manager have where ESG considerations played a key part in the final investment decision? Did corporate engagement or proxy voting play a significant part in the final decision?
- What factors does the Fund Manager focus on more – environmental, social or governance factors?
- If the Fund Manager is a PRI signatory, how has the Fund Manager’s investment process changed since signing up?
- Does the Fund Manager use any third-party research with respect to the integration of ESG factors in their investment process? How do they use the information? (Portfolio analysis, equity research, screening, or quantitative analysis).
- Thanks for the pretty sales pitch, with clearly articulated examples, now tell us about the rest.
Screening
Screening is the most mechanical approach. A ‘screen’ can be applied by a Fund Manager to exclude or include securities in a managed fund. To understand the screen used by a Fund Manager there are two key considerations:
Nature of the business activity
For example, companies involved in tobacco, fossil fuels, gambling, controversial weapons, or alcohol maybe excluded. On the other hand, companies with lower carbon emissions might be part of a positive screen and therefore more likely to be included.
Criteria used to define the screen
The Fund Manager could define this several ways. Some definitions are more objective than others. Financial metrics such as revenue are easy to pinpoint e.g., “companies generating more than 10% of revenue from alcohol”. Conversely, a Fund Manager may positively screen for companies with higher ratings from an ESG data provider. These ratings incorporate multiple underlying metrics.
Research IP seeks to answer the following questions when evaluating the Fund Manager’s approach to screening:
- Where is the line drawn on exclusions? How are securities defined and excluded? Be cognisant of the terms used in managed fund disclosures, for example “material”, “significant involvement”, “directly involved”, or “x% of revenue”. Ultimately it is about materiality and proximity to the business activity. Note: this is directly relevant to default KiwiSaver providers.
- How does screening affect portfolio construction? How does the portfolio compare to the benchmark? Is there more concentration in certain sectors?
- How does the Fund Manager think about overall portfolio risk after applying screens?
- Does the Fund Manager have any recent examples of an ESG issue that caused them to exclude, decrease, or increase an investment?
- If best-in-class screening is used, what are the ranking thresholds and why did the Fund Manager choose these?
- Does the screening process simply reflect a ‘box ticking’ approach?
Thematic/Impact
Thematic/Impact investing aims to achieve non-financial objectives (as well as a financial return). The intentions of a Fund Manager versus actual contribution to non-financial objectives should be examined. The important consideration regarding contribution is how material an investment is. In this context materiality refers to the influence on outcomes, which in practice relates to the size of an equity investment or the agreed bond covenants. Materiality is a key element that differentiates a Fund Manager in public markets versus one in private markets.
Research IP seeks to answer the following questions when evaluating the Fund Manager’s Thematic/Impact approach:
- Is the Fund Manager investing in unlisted debt/equity? Note this asset class is not typically available to retail investors.
- What is the size of an individual investment in reference to the issuer? How much influence does the Fund Manager have on decision-making? How much can you attribute impact to non-financial objectives to a Fund Manager?
- Does the Fund Manager seek to address the UN SDGs? Which specific SDGs? What examples does the Fund Manager have of specific SDGs already being addressed in the portfolio?
- What metrics is the Fund Manager using to assess the impact on non-financial objectives? Internal metrics or external data providers?
- How often and where is the Fund Manager reporting the impact metrics?
- What level of continued engagement and analysis is the Fund Manager applying to ensure investments achieve the non-financial objectives?
The latest version of Beneath the Surface of Responsible Investing can be found here.
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