There’s plenty of evidence that sustainable investing is gaining traction as an important consideration in institutional investors’ strategies and portfolios.

Take, for example, the fact that the number of signatories to the United Nations’ principles for responsible investment has steadily increased; regulators in many jurisdictions have mandated that institutional investors explicitly consider their environmental, social and governance views; and many committees are responding to external and internal pressure to frame their investment process within the context of clearly articulated sustainable beliefs.

However, while many committees appreciate the importance of sustainable investing in theory, they often have difficulty reconciling their fiduciary responsibility to manage a plan’s investment returns within a framework that may constrain their portfolio construction decisions and dilute potential returns. Plans that have a longer experience of investing within a sustainable framework have experienced mixed financial results.

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Nevertheless, some institutional investors have started exploring structures that link sustainable investing with long-term performance. More recently, improved data availability in relation to sustainability factors offers compelling evidence that tilting portfolio exposures towards assets managed according to long-term sustainable investment principles and awareness of non-financial return drivers adds value over time. At a very high level, there are consistent themes among investors that have taken a more proactive approach to sustainable investing.

First, it’s important to define what sustainable is. In very broad terms, the term refers to investments that deliver returns that will last over the long term, rather than narrowly defining it as green investments. For example, it encompasses assets that are resilient to the impact of climate change or provide sustainable returns in light of other concerns such as societal issues (demographics and inequality), resource scarcity and technology.

So how can asset owners take sustainable investments into consideration when approaching their portfolios? For institutional investors that have had success with the approach, it generally involves more than a simple screening of certain stocks or ticking boxes when voting on company proxies. Sustainable investing isn’t about a single issue (such as climate change) or a single asset class (such as equities) but is fully integrated with other aspects of investment thinking.

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More specifically, institutional investors in the area will devote significant upfront time to determining their beliefs around sustainable investing. Ideally, investment committees, trustee boards and even pension plan members would reflect on their beliefs and then develop policies to help ensure the portfolio reflects them. That could mean an investor stating it expects its asset managers to consider environmental, social and governance risks into their investment decisions. It could go further, actively targeting strategies that tilt towards companies with good environmental, social and governance credentials or that provide exposure to assets that will benefit from long-term trends in those areas.

Subsequently, investors that successfully incorporate sustainable investing ensure long-term strategic allocations, evaluated within the context of their overall macroeconomic outlook, reflect their beliefs. It’s increasingly important to factor in those long-term investment themes and evaluate the expected forward-looking distributions for risk and return. Specifically, the impact of sustainable investing biases are evaluated using scenario analysis, in which long-term economic scenarios integrate sustainability into the risk-management assessments. Robust modelling can help to stress-test portfolios and build conviction that tilting them towards more desirable sectors from a sustainable investing point of view can improve the likelihood of a better long-term performance.

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If the investor can equate sustainable investing biases in the portfolio with better long-term performance, the next step is to determine the optimal way to implement those beliefs. Fortunately, the market has evolved from a scattering of very narrowly defined environmental, social and governance products to a much more robust suite of available offerings that seek to capture the effect of sustainable investing through a cost-effective, liquid and scalable set of sustainable betas, with the initial focus on equity. Those betas can help to design a passive investment strategy or serve as a benchmark for active approaches.

Sustainable investing appears to be at a crossroads. Historically, there was a bias — supported by limited experience — that embedding those beliefs into an investment process could dilute returns. However, as investors have re-examined their definition of sustainable investing and considered the longer-term impact of tilting portfolios to the factors that would align with those beliefs, there’s a realization that sustainable investing and performance may no longer be mutually exclusive. That style of investing may experience a renaissance due to the combination of robust scenario analysis suggesting sustainable investing may reduce portfolio risk without sacrificing return, as well as the availability of new products.

Marcus Turner is a director and senior investment consultant at Willis Towers Watson.
Copyright © 2017 Transcontinental Media G.P. Originally published on benefitscanada.com

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