Since the emergence of “Modern Portfolio Theory” and the “Capital Asset Pricing Model” in the late 1960s, institutional investors have taken a quantitatively driven approach to portfolio construction, looking to create portfolio diversification and obtain better risk-adjusted returns by balancing their asset-class exposures. This journey has seen several important advancements in thinking about how to optimally achieve desired results.
Funds that want to take the total portfolio approach first need to get the total portfolio view. To do that they not only need data – and lots of it – but a rock-solid understanding of exactly how they’re going to use it.
ESG gets harder, but hardly impossible
At a recent off-record briefing, one fund manager posed the rhetorical question to journalists of whether even investors’ ethics were only a function of falling interest rates. Certainly it’s been easier to apply an exclusionary overlay in a decade when pretty much everything but fossil fuels has done well and the main driver of returns has just been a matter of showing up to the party.
But while the short-term outperformance of fossil fuels is unlikely to sound the death knell for ESG and sustainability, it could push investors to rethink their own commitment to the principles – even if that commitment is based on a narrow view of what ESG can be.
“At this point, when we’re seeing some of these funds that have been very exclusionary of fossil fuels at a time when fossil fuels have done very well, they’re obviously going to suffer,” says Daniela Jaramillo, director of sustainable investing at Fidelity.
“The challenging part of that is that people tend to put ESG all in one bucket and think that there is a trade-off. I’m concerned that we might go back to that concept that there is a trade-off following the recent market movements that haven’t benefitted the growth stocks that many ESG funds hold.”
Indeed, a recent Schroders’ survey of 770 institutional investors found that 53 per cent of respondents listed “performance concerns” as a key challenge of ESG and sustainable investing. While it’s tempting to think of this as the old worries about a sustainability or ESG “tax” warmed up, that number had actually fallen from 45 per cent in 2020 to 38 per cent in 2021 and had been falling year-on-year before that period. Less sophisticated individual investors and super fund members are likely performing their own reassessments.
“People will only be engaged enough to read the headlines,” Jaramillo said. “It’s not like the everyday investor is signing up to webinars, and this is where we need financial advisers for example for us to be able to transmit this information to them. The super funds are really trying to engage with members, to the extent that members want to be engaged with on this issue – but that’s the biggest issue.”
Compounding this is the fact that younger investors have historically prioritised exclusion over engagement, even as the world’s largest asset managers and owners are trying to work collaboratively with those companies most exposed to the economic impacts of climate change to change their business. Success on engagement “is hard to attribute and hard to track,” Jaramillo says, and as a result, those who question its efficacy “have a fair point.”
“The challenge is in demonstrating and at least having a few examples where (the outcome of engagement) can be attributed back to investor pressure and being able to show some evidence… That’s what’s going to get people to understand the benefits of that,” Jaramillo says.
“The other missing piece is the role of public policy advocacy – and that investors should be sharing those views, whether it’s through regulators or industry bodies, or also talking directly to the companies about their own lobbying efforts – how they’re engaging with public policy and whether that’s aligned with the strategies they’re telling us they’re sticking to.”
But investors are also developing much more sophisticated escalation frameworks to put the proverbial shot across the bow of companies that might otherwise have been happy to coast on promises alone.
“We’re not just going to engage forever and have a no divestment policy,” Jaramillo said. “… We say now that these are the minimum requirements that a company exposed to climate change has, and if they’re not meeting them we’ll vote against the board of directors when we feel that everyday discussions are not necessarily helping.
“The same with diversity. That’s engagement with consequences – clear escalation processes that allow you to demonstrate where a laggard has not been moving.”
