With sustainable investing gaining significant popularity, it’s critically important for defined contribution plan sponsors to understand how underlying investment managers integrate environmental, social and governance factors into their investment processes.
“Let’s think about ESG not as a separate process and overlay or a yes or no question, but as a core reinforcing part of how we deliver on our fiduciary duty,” said Kathrin Forrest, equity investment specialist at Capital Group, during Benefits Canada’s 2022 Defined Contribution Investment Forum in January.
Since the early 2000s, ESG investing has moved into the mainstream and the field is evolving quickly, she said. A recent survey of institutional investors by Capital Group found 84 per cent of North American respondents consider themselves ESG users or adopters. A combined 62 per cent of those respondents said they did so to meet client needs, improve performance and enhance risk management, while 24 per cent cited a desire to do good and 13 per cent mentioned regulatory and peer pressure and reputation concerns. Three-quarters of respondents felt ESG wasn’t a passing fad.
According to data from the Global Sustainable Investment Alliance, there has been significant growth of assets invested in sustainable investing strategies between 2016 and 2020, but the increases weren’t uniform across approaches. Assets invested in a negative screening approach, where investments are excluded based on various values, decreased. Other approaches saw mixed intake, but ESG integration, an approach that involves the systematic and explicit inclusion of material ESG factors into investment analysis and decisions, has experienced the most substantial growth, reaching US$25,195 billion in assets by 2020.
Forrest said plan sponsors that are trying to evaluate a manager’s claim of ESG integration should make sure they understand the manager’s objectives and that those objectives align with the plan’s goals and investment values. Plan sponsors should also look for “transparency by the managers on the consistent application of process.”
At Capital Group, the goal is to “embed ESG considerations directly into where and how we form our investment views,” she said, noting the firm’s approach has three components: ESG frameworks, a multi-layered monitoring process and engagement and proxy voting.
Its frameworks are developed by investment teams to identify the most material ESG issues to their respective industries, based on their joint experience and perspectives across regions and asset classes. Using the example of the U.S. health-care services sector, Forrest said Capital Group’s analysts built on experience and research from the Sustainability Accounting Standards Board and engagement with issuers in the space, then created a list of potential ESG issues based on what had created and destroyed value in the past to find the best performing companies.
The monitoring process involves using multiple external sources to screen all of the companies in which Capital Group invests to ensure it isn’t missing any ESG issues, which Forrest said helps the firm “understand how the market more broadly views these [companies] and it’s meant to avoid confirmation bias for us.”
Between five to 12 per cent of holdings are flagged per month on average, she said, noting any flags must be addressed by the responsible analysts and the firm has escalation procedures for serious ESG-related controversies.
Forrest said companies with “unconventional” corporate governance structures tend to generate more flags and certain sectors are flagged more frequently due to the nature of their business. Monitoring also tends to flag events rather than systemic issues, meaning it can be “backward looking.”
When it comes to engagement, Capital Group doesn’t outsource its proxy voting activity or issue automated standing instructions on how to vote, she said. Instead, it looks at companies on a case-by-case basis and vote “to affect meaningful change.”
The firm is dedicating more effort and resources to researching diversity and climate issues as a source of long-term value creation. In February last year, Capital Group sent a letter to board chairs of 1,600 companies to lay out the workforce diversity and disclosure best practices it’s now focused on.
“We’re not activists, our approach is to work with companies. As active managers we can decide to invest or not, but engagement and voting as an escalation can be effective tools to support investment results and help manage risk.”
Contrary to popular belief, Forrest said a focus on ESG doesn’t hinder investment returns, but instead is another lens to understand what will make companies successful into the future. “It’s one additional area of inquiry that can help you strengthen your investment conviction.”
Read more coverage from the 2022 Defined Contribution Investment Forum.