ESG integration outside of equities not always straightforward

Liza McDonald, Head of Responsible Investment at Aware Super

ESG Outside of Equities

Integration Can Be Challenging

How do you integrate ESG outside of fundamental listed equities strategies? There is not always an easy answer, asset owners said at a recent PRI event.

Recent headline cases involving Rio Tinto’s Juukan Gorge debacle and AMP’s executive sexual harassment case have shown that asset owners have become increasingly more assertive in enforcing their environmental, social and corporate governance (ESG) policies.

It has shown that the days where ESG was in the hands of the legal department, which simply added a form of disclaimer to the annual report, are well and truly over.

But where engaging with large listed companies is a clear and well-understood strategy, integrating ESG into other asset classes in the portfolio is not always straightforward.

During a session on effectively incorporating ESG into the selection, appointment and monitoring of asset managers at the PRI APAC Digital Symposium, held last week, several asset owners acknowledged the challenges of integrating ESG into particular strategies, including hedge funds and quantitative managers.

For example, engagement is particularly challenging for the more quantitatively minded investors, Alexis Cheang, Partner for Responsible Investment at Mercer, said during a panel discussion.

“Quantitative equity is an interesting strategy. It applies a lot of data analysis and, in our view, it doesn’t lend itself particularly well to active ownership or engagement,” Cheang said.

Alexis Cheang, Partner for Responsible Investment at Mercer

Quantitative equity is an interesting strategy. It applies a lot of data analysis and, in our view, it doesn't lend itself particularly well to active ownership or engagement – Alexis Cheang, Mercer

“The portfolio management team is building and investing in algorithms, they’re designing risk models and alpha models that are intended to deliver returns across the market broadly, but they’re not particularly strongly suited to engagement.

“So when you’re evaluating quant managers, I would suggest you want to ask questions about those valuation models, about the alpha model and the risk model, but also ask them that if your approach doesn’t lend itself to stewardship, which is one of the key principles under the PRI, then how do you approach that?

“Do you partner or how do you bridge that potential gap in voting and engaging with such a huge portfolio of companies?”

She said Mercer had to develop a separate set of guidelines for evaluating quantitative equity managers on ESG to reflect the fact their investment approach is very different to more traditional fundamental equity managers.

Hedge Funds

Liza McDonald, Head of Responsible Investment at the recently rebranded Aware Super, formerly known as First State Super, said hedge funds provide another challenge. Often the standard ESG questionnaire that forms the basis for further assessment contains questions that don’t apply to these types of strategies.

“Needless to say, we have been challenged on how we rate hedge fund managers,” McDonald said.

“We will send out our RFP (request for proposal) and due diligence questionnaire and you will eventually get a phone call [where the managers says:] ‘We actually don’t know how to answer a lot of the questions in here.’

“And that’s really when we adapt our approach on how we assess them. There’s obviously a role from an overall strategy perspective that we want to invest in hedge funds for a number of different reasons, whether it be liquidity or from a strategic perspective.

“So it’s not a matter of, okay, you don’t integrate ESG, we won’t appoint you or we won’t select you. What we’ve tended to find, particularly where it might be more [about] derivatives, or more synthetic exposures, is that we’re looking for alignment on issues and also on themes around ESG and how the organisation actually thinks about that.

“Does it actually think that ESG is important and … are they willing to talk to us to understand what they do?

“But it certainly has been a challenging area.”

Make it Formal

Part of maintaining a successful ESG policy is measuring and reporting and McDonald said it is important to be upfront with your manager about reporting expectations and enshrining them in the investment management agreement (IMA).

“We have a number of clauses that go into the body of the agreement with fund managers and that will be around the reporting that is required and also an acknowledgement that we are a PRI signatory, we have a policy on ESG integrations and we expect the manager to acknowledge that policy,” she said.

Including ESG reporting requirements in IMAs is important because the fund has found in the past that some managers agree on these requirements in the initial discussion, but backtrack once they see it written in a formal agreement.

“You would hope and then expect when you actually get to signing the IMA that there are no issues in terms of agreeing to some of those, [but] we have had some instances where we’ve kind of gotten to there and it’s like: ‘Oh no, I don’t know that we could commit to that,’ or ‘I don’t think we could report that.’ Well, actually there are minimum requirements and during the due diligence we have discussed all of these particular issues,” McDonald said.

And once an IMA is signed, managers should also be thinking about how they can improve their reporting. But McDonald said those managers that agree to the set terms often display a proactive approach to ESG.

“Then there’s obviously that ongoing dialogue where we might want to improve reporting or improve different things. And we generally tend to find most of our managers are actually coming to us and say: ‘This is how we want to improve what we’re reporting to you.’ So it’s about having a really open and transparent dialogue and getting it formalised in your IMA,” she said.

Let Them Know You’re Watching

Fellow panelist Kim Chong, Head of Risk Management and Compliance at the Hong Kong Monetary Authority (HKMA), agreed with McDonald and argued that asset owners need to be clear that ESG is a metric that managers are judged on.

“Make sure that they know that they’re being evaluated and not just on performance in terms of returns, but also on the ESG activities and performance,” Chong said.

“Where managers perform mediocre and they are not performing on ESG, they may be severely assessed and, at the extreme, we may terminate mandates if that ESG performance is way below what we expect.

“Obviously, if the return performance is fantastic, then termination may not be an issue. But ESG considerations come under our evaluation mechanism.”

One issue he looks at in particular is the voting behaviour of managers. If they always vote along with management, even when other stakeholders don’t, then there might be an issue.

“We will look at the voting records and if they are voting a hundred per cent for the management that in itself is not wrong. But we have similar asset managers across our portfolio and if there are other managers that have voted against similar resolutions, then we will want to understand why they are always voting with management,” Chong said.

Kim Chong, Head of Risk Management and Compliance at the Hong Kong Monetary Authority

Make sure that they know that they're being evaluated and not just on performance in terms of returns, but also on the ESG activities and performance – Kim Chong, Hong Kong Monetary Authority

“So we pick up evidence from the results prior to going into the meeting and understand where they’re coming from. Sometimes they may have good reasons for voting in certain ways because they might already be engaging with the companies themselves and they have sufficient comfort that ESG has been looked after in that process.”

HKMA also has a portfolio of unlisted assets, where its voting policy doesn’t apply. Chong takes a hands-on approach here and engages with each manager to see how they are faring on ESG.

“For the private investments and private equity investments, I do separate engagements. It’s a slightly different approach, obviously, because there’s no voting. What I like to do with that is I visit the general partners. Every year, I make one or two trips to see how they integrate ESG in the process,” he said.

“For example, one of the areas that we look at is an infrastructure mandate. We look for evidence that they have a strong ESG set-up because infrastructure may require going into emerging markets, or going into greenfield projects, or building power plants, building infrastructure projects that may involve displacing local communities and so forth.”

He is also keen for managers to continue to educate themselves on ESG topics and wants to see evidence that they go out and actively seek this knowledge.

“I look for evidence that they have annual seminars and conventions where the top managers share experiences together. So when I go out to engage and monitor the activities, I look for these sort of ESG activities,” he said.

Women in Finance


[i3] Insights is the official educational bulletin of the Investment Innovation Institute [i3]. It covers major trends and innovations in institutional investing, providing independent and thought-provoking content about pension funds, insurance companies and sovereign wealth funds across the globe.