Towers Watson: Multiple elements add up to sustainable investing

Updated Sept. 13, 2012.

A truly sustainable investment process should combine short-term and long-term elements that take into consideration not only financial performance, but also risk and cost control that is fair across generations of stakeholders, according to a new research paper published by Towers Watson & Co.

“Because of the transformations in world economies, politics and capital markets, long-term investing — sustainably — is actually a superior approach to the way we invest at the moment,” said Roger Urwin, London-based global head of investment content at Towers Watson, in a Sept. 11 press conference about the paper. The paper, “We Need a Bigger Boat — Sustainability in Investment,” is derived from a research project dubbed Project Telos, and was conducted with Oxford University and supported by 22 money managers and other pension experts. (The paper is available at www.towerswatson.com/research/7818.)

“Just as we have ‘profits with purpose’ in the past, we will have ‘performance with purpose’ in the future,” said Mr. Urwin, referring to the phrase ‘profits with purpose’ coined by Indra Nooyi, PepsiCo.’s chairman and CEO, to describe socially responsible corporate strategies.

Global deleveraging along with the impacts of increasing scarcity of resources and aging demographics have introduced “an extra dimension” to the investment process, Mr. Urwin said. As a result, those asset owners and money managers pursuing “a broader mission” that goes beyond purely financial goals can reap risk/return benefits over time.

For institutional investors, a road map toward sustainable investing should evolve toward a “dual-goal” mission that takes into account actual returns balanced against externalities — defined generally as unpriced costs or benefits. An example is “the risk of companies and sectors being deemed liable for the effects of their actions on climate change,” according to the paper.

“It’s about seeing risk in a different way,” Mr. Urwin said.

According to Towers Watson’s own data based on the long-term investment mandates it advises, returns have averaged 6% above inflation annualized over the past nine years on an absolute-return basis. Compared to the traditional mandates with 12-month or three-year investment horizons, these mandates can stretch over a period of 10 years, allowing for a more integrated sustainable investment strategy.

Based on empirical evidence, “it’s very clear that over the last 10 years, the time horizons (for investors and analysts) have been getting shorter,” said Emma Hunt, senior investment consultant in the sustainable investment team at Towers Watson based in London. (Ms. Hunt was referring to research recently conducted by Andrew G. Haldane, executive director for financial stability at the Bank of England, London.)

“As we know, a lot of corporate governance issues can be beyond a three-month time horizon, and environmental issues can be beyond an 18-month horizon,” Ms. Hunt added. “These issues are not being factored in to the pricing structures or discounted cash flow structures accurately.”

At Towers Watson, “this is the favored approach,” said Mr. Urwin, who added the company has about 100 such assignments. “These mandates have led to lower cost, lower turnovers of managers, and lower turnovers” of investment assets. In addition, the Sharpe ratio — a measure of risk-adjusted performance — is generally higher compared to a typical equity mandate.

Furthermore, the use of benchmarks is changing. “If you look at investment benchmarks, (a benchmark) does two things: It drives the portfolio, and it’s the measure of whether a manager is doing a good job,” Mr. Urwin said. In Tower Watson’s long-term mandate, “the benchmark does represent an opportunity set that is meaningful in a performance measurement sense, but it shouldn’t drive the portfolios themselves.”

Such shifts in investment thinking act as supports for what was described as a road map for sustainable investing aimed at institutional investors. Three key stages are recommended: establish strategic principles, including mission, values and beliefs particular to the fund; ensure the necessary resources and capabilities are in place, including a robust governance structure; and develop and implement the investment process as appropriate.

“The demand on governance comes from being able to manage short-term market dynamics while also devoting time and energy to considering the long-term viability of investment strategies, thereby improving decision-making,” according to Gordon L. Clark, professor at Oxford University’s Centre for the Environment, Oxford, England.

Furthermore, the relationship between managers and asset owners also evolves in the sustainability road map. According to the research paper, “if asset owners adopt sustainable investing principles, this will affect their choice of asset managers to act on their behalf.” For asset owners, on the other hand, decisions such as whether to terminate managers should not be based on short-term performance.

“It’s a long journey, and any journey will hit potholes in the road,” said Carole Judd, co-author of the research paper and member of the Thinking Ahead Group at Tower’s Watson. “Part of the challenge as an asset owner is to be able to trust the manager. … This is more of a partnership arrangement.”