Institutions shift governance focus
by Elliot Hentov
Investors are rapidly adopting ‘environmental, social and governance’ strategies. This is, however, a recent phenomenon, with only one-in-eight investors pursuing ESG approaches for longer than six years.
It is surprising that the patterns of ESG investing among official and non-official investors are so similar, given that the former are more subject to policy influence.
According to data from a State Street Global Advisors survey of almost 300 institutional investors, 75.3% of official institutions implement ESG, the exact same percentage as non-official institutions. The share of assets under ESG, too, is close, with an average of 26.8% of official institution assets against an average 25.8% of non-official institution assets implemented under ESG. The dataset features 291 institutional investors across 29 countries, 93 of which were official institutions. Of this group, 65 were public pension funds and 28 were sovereign funds.
Closer examination of the survey shows that similarities are apparent across all institution types. The data confirm the penetration of ESG is relatively shallow across most institutions, with close to half of ESG adopters implementing it across less than 10% of their assets (see Chart 1).
Long-term investment leads ESG thinking
All investors share the same relative expectations regarding ESG and place particular significance on boosting long-term performance and limiting risks. On the former, views are broadly similar on the potential of ESG to deliver outperformance, with sovereign funds having a slightly higher expectation of medium- and long-term returns than other official institutions.
There is broad consensus among investors on the expected protection against downside risks, but public pension funds attach marginally greater importance to the protection which ESG can provide against volatility. A possible reason for this is that public pension funds prefer to avoid single-company risks from regulatory breaches or public criticism.
There is less cohesion when looking at the underlying forces that compel institutions into ESG-investing (see Chart 2). Groups’ views of ESG’s desirability is likely to be affected by the opinions of beneficiaries or managers. Those institutions which treat ESG favourably may do so for different reasons, such as following the practice of peers or as a component of the institution’s core values, and may operate according to different frameworks which could help or hinder ESG implementation.
Respondents to the SSGA survey could choose one or more of six reasons for adopting ESG strategies: linking with better investment practices; fostering of a long-term investment mindset; example of peers; regulatory demands; beneficiary demands; and the beliefs of senior leadership. While the long-term investment motivation leads the poll, the secondary rationales diverge and reflect different institutional frameworks.
Public pension funds pay special heed to the demands of beneficiaries. If a pension fund is run on behalf of a public institution, then either the institution itself may be using the fund to enhance and communicate its public policy goals, or the institutions’ employees may be channelling their demands through available mechanisms such as trade unions that may be stronger in the public sector. Publicly funded social security institutions could be under political pressure to adopt ESG strategies. Beneficiaries of large corporate pension plans are less likely to act as a homogeneous group, and it is more difficult for beneficiaries of insurance to do so.
By contrast, beneficiary demands feature less among sovereign funds, in part because the concerns of their stakeholders and the national interest at large are instead represented by a senior leadership team, often drawn from the political ranks. Such a group would make key investment decisions and would influence the adoption of ESG. However, some have an incomplete institutional structure and lack a clearly defined liability profile.
Governments may change their views of sovereign funds, their size and purpose, and a change in political leadership may change the government’s approach to these groups. Some governments accumulate capital in sovereign funds as a best practice, but lack clearly defined strategies for them. This results in sovereign funds not having full visibility of beneficiaries’ preferences, meaning they focus solely on proven portfolio techniques. Sovereign funds, too, are more likely to cite peer pressure as an ESG driver than public pension funds.
Constraints on ESG adoption
An important aspect of ESG investing is its interaction with outsourcing. The survey data suggest those institutions which are more likely to outsource investment functions are also more likely to adopt ESG (see Chart 3).
All asset owners must balance in-house investment management and outsourcing. These decisions involve many considerations, not least the size of the asset owner. In many cases, investors outsource those components of their asset allocation where they feel they need specialist knowledge. In that case, those institutions which prefer ESG may have a higher likelihood of hiring external managers to implement it. On the other hand, those which are more open to outsourcing in general may be exposed to a greater variety of strategies and to more complex products, including ESG investment.
While it is possible for official institutions to adopt some ESG considerations on their own, the data suggest meaningful ESG implementation may require asset managers specialised in such products. Institutions with limited interest in ESG are unlikely to increase it through outsourcing, but those institutions which are interested but are in some way constrained with regard to outsourcing may find it difficult to proceed by themselves.
The survey asked respondents to state whether any of the following investment themes featured significantly in their investment process: global political tensions, income inequality, gender inequality, climate change, resource scarcity, or other environmental topic.
Sovereign funds are less likely to bring in specific investment themes (see Chart 4). One explanation is that a focus on national wealth preservation, which to date has remained the key focus of most sovereign funds, prevents them from actively seeking investment topics. This is supported by the fact they are less likely to consider ‘global political tensions’. It is less clear, however, why they take more interest in income inequality than other issues. It is possible that high income inequality in many commodity exporters may generate interest from sovereign funds based in them.
The data point, too, to the importance of the horizon at which different institutions invest and evaluate their investment performance. There are significant differences between official and non-official investors, but relatively little difference between just official institutions. The most striking finding is the considerably longer investment horizon of official institutions; close to half of which invest on a horizon of over 10 years, compared to less than a third of non-official institutions.
Such a difference should have a profound impact on ESG usage, as ESG is often associated with longer-term investment strategies. However, the data show that a relatively large difference in ESG usage between sovereign funds and public pension funds is juxtaposed with their comparable investment horizons. ESG strategies are multi-faceted and the interaction between the time horizon and their adoption is likely to be more complex and non-linear.
The length of official institutions’ investment horizons has many other implications, as it may flow directly from their institutional mandate. In this regard, public pension and sovereign funds fulfil policy mandates that incorporate public finance and even macroeconomic implications which are typically longer-term than those that private-sector investors must address.
Despite shared accountability to public owners, public pension funds have advanced further in the implementation of ESG than sovereign funds.
There is no evidence to suggest sovereign funds are intrinsically more reluctant to adopt ESG. On the contrary, respondents to the survey from sovereign funds appeared to show considerable enthusiasm about many ESG aspects. More probably, certain institutional features of sovereign funds – notably the extent and the mechanics of engagement with external asset managers, as well as incomplete development of their mandate – may be hindering them from adopting ESG strategies to the same extent as public pension funds.
Elliot Hentov is Head of Policy & Research, Official Institutions Group, at State Street Global Advisors.