Identify the right manager for your responsible investment mandate through specific due diligence questionnaires.
More and more institutional investors are adopting responsible investment approaches and signing in for UN Principles for Responsible Investment (PRI) or local stewardships codes, including some of the largest asset owners in the word (GPIF, CalPERS, APG, AP3, etc.).
Indeed, since its launch in April 2006, the number of asset owners adopting the UN Principles for Responsible Investment (PRI) has grown from 100 to over 1,800 with a total AUM of around $ 90 trillion. European and North American Institutional investors embraced sustainable investing more than other regions. However, in the last years, the trend is also growing elsewhere and even in some emerging markets.
As per a study done by McKinsey & Co. the three most common reasons for institutional investors to pursue sustainable investing are: enhancing returns, strengthening risk management, and aligning strategies with the priorities of beneficiaries and stakeholders. Investors who are still holding back believe sustainable investing ordinarily produces lower returns than conventional strategies, but research findings are proving the contrary.
Listed equities have been the main asset class in which environmental, social and governance (ESG) principles have been applied. Nevertheless, further progress is noticed in making other asset classes more sustainable (for example Commodities, Hedge Funds and Fixed Income with two figures increase in 2018 compared to the previous year).
Asset owners employ various ESG approaches in order to meet their investment and responsible investment objectives. While some approaches may sound similar, implementation, in general, is different and will be reflecting the asset owner’s priorities and take into account the type of investments (asset class, direct or indirect).
This article focuses on the impact sustainable investing has on investment managers screening and monitoring activities and how this is reflected on asset owners due diligence questionnaires.
Selecting the right manager for responsible mandates has a significantly different approach from hiring a manager for conventional mandates. Many institutional investors have integrated ESG elements into their due diligence processes for external managers either through specific questionnaires or a continuous dialogue with managers.
However, it doesn’t mean that you can only add a couple of questions or requirements in connection with ESG goals to the standard due diligence questionnaire. On the contrary – search for the proof of implementing ESG factors affects the whole questionnaire.
Manager’s general investment approach and in a way how a specific product is governed can widely differ in the context of ESG factors. You can identify the desirable level of ESG practice at the firm level, however, if you select a product where ESG factors are ignored, the final ESG impact of investment can be limited or even harmful. Or it can be vice-versa – you can select a product with well-integrated ESG factors, but if the manager lacks the commitment to incorporate these factors, the investment result will be negative.
That’s why it is extremely important to ask the right questions from the start, to get a high-level overview of manager’s approach and objectives, investment policy, time-horizon, asset classes and governance on both levels – the firm and the product.
Furthermore, many examples show that even though the incorporation of ESG objectives is stated in investment policies and process descriptions, it is not equally present in investment processes. How to ensure that the investment manager you select for your responsible investment will truly incorporate ESG factors into the decision making and portfolio construction?
You should ask the right questions through your whole due diligence questionnaire. The main topics to cover along with some sample questions are listed below.
I) ESG factors high-level implementation at the firm and product level
- Investigate investment approach and objectives related to ESG factors: you may ask about competitive ESG strengths, about using ESG index benchmark, and about ensuring that ESG issues are embedded into investment decisions. You may check if there is an alignment of the product with the firm-level approach and if the manager’s objectives and approaches apply to the selected
- Assess the investment policy in connection to the ESG goals: you should check which policy definitions the firm uses for ESG factors across the firm, how often the policy is reviewed and if the approach to tackling ESG issues has evolved over time. You can also ask how ESG incorporation regarding a certain product might change due to evolving responsible investment policies.
- Investigate time horizon practices for ESG-related investments: you may ask how the manager resists short-term pressures, how the firm promotes the long-term success of the companies it invests in, and how its ESG objectives match the investment time horizon of a particular
- Get an overview of ESG competencies in asset classes: you may explore if the investment approach, ESG staffing, and philosophy vary among asset classes, how the manager incorporates ESG issues in the targeted asset class and what is the depth of ESG product offering in the asset class the manager is interested
- Find out about the level of ESG objectives integration in the governance: you may ask about the manager’s governance structure, roles, and responsibilities regarding ESG It is also good to know if the manager has a dedicated ESG team and if not, you should check if portfolio managers and risk team are trained to deal with ESG issues.
II) ESG objectives implementation in investment decision making, portfolio construction, engagement, voting and reporting
- Explore ESG objectives incorporation in investment decision making: you may explore the manager’s previous challenges related to ESG objectives incorporation, and how ESG incorporation affects the investment decision making when it comes to investment valuations. You may ask for examples of how the product-related ESG issues have influenced investment decision making so far, which ESG factors affect portfolio and why, and how the manager ensures that available ESG data is used to benefit the product.
- Examine the influence of ESG factors on the portfolio construction: understand the used techniques: negative screening, positive screening, and proactive engagement and how they are implemented. You may check what portfolio criteria the manager uses, how ESG issues interact with these criteria, and how the firm plans to mitigate ESG risks in the holdings. You should also ask how the weight of the remaining stocks will be adjusted and how ESG issues in the process will be considered if a stock, sector or country is removed from an index.
- Find out how engagement and voting function in the context of ESG goals: you may ask if the engagement process is structured, and how the manager engages on ESG issues for the product which differs from the firm-level practice. You should check how the firm ensures that ESG factors are integrated into investment decisions. When you explore the voting, ask how the firm would act in the situation of misalignment between its voting policy and yours. You should also find out how the voting works, and how the voting outcomes are implemented into investment decisions.
- Get an overview of reports about ESG integration: you may check how reports about ESG integration, performance and impact look like. You may ask how the manager communicates ESG integration to the stakeholders, and what performance indicators are used to measure ESG impact.
As more institutional investors consider implementing ESG factors into their investments, they are likely to face some challenges, and this can be experienced during managers due diligence.
In reviewing the experiences of leading institutions, McKinsey & Co. found out one theme that stood out: sustainable investing is more effective when its core activities are integrated into existing processes, rather than carried out in parallel. Creating appropriate due diligence questionnaire is just one part of this integration, and can make or break your efforts in the search for the best manager for your responsible investment mandate.