A Functional ESG Perspective for Pension Funds

As pension plans around the globe adopt ESG considerations in their investment process, albeit to varying degrees, they’re looking more closely at how ESG can be optimally treated in terms of the portfolio’s overall risk management. An ESG approach means different things for different pension funds, they may look at disclosures and benchmarks in different ways, and portfolio implementation can have a range of unintended consequences.

“We have a very functional, practitioner view of ESG,” said Jennifer Sireklove, Managing Director of Investment Strategy at Parametric, an asset manager who offers systematic equity strategies for clients with complex mandate design. “In our client-directed work, we try to identify the ESG goals of each client and then map those goals to a portfolio we can implement,” she said, at Pensions & Investments’ Canadian Pension Risk Strategies virtual series in October.

“The first thing we listen for is: Do investors want to change which companies they invest in? Or, do they want to change the behavior of the companies they're invested in? Or both? That’s a critical distinction and the different considerations get pretty granular,” said Sireklove, on the session titled ‘ESG’s Impact on Pension Risk Management: How are Organizations adopting ESG within a De-Risking Framework?’

If it’s the former question, investors may be motivated by ethical considerations, global norms, or jurisdictional rules around what's acceptable or not—by return enhancement and risk mitigation—she added. Those preferences impact implementation and how success would be evaluated. If it’s the latter question, “We think about who will actually lead the active ownership work? Will that be us as asset manager, the asset owner, or a third party? What will it cover? How does it interact with the portfolio construction decisions? A lot of our view on ESG is really about understanding and appropriately implementing the client view on ESG.”

Sireklove noted that Parametric’s own house view on ESG is not using it to beat the benchmark. Any proprietary strategies for clients are intended to gain market exposure. “We are focused on financial materiality in terms of our active ownership practices. But, again, it's less about trying to beat the market with ESG, and more about trying to lift market beta and make all companies better.”

While Parametric works more predominantly with pension plans in the US, Australia, and the Nordics, Sireklove said she looks to Canada’s leadership in some areas. Examples are Ontario's Pension Benefits Act requiring ESG disclosure by pension funds, and the Expert Panel on Sustainable Finance’s financial taxonomy for ESG incorporation. “And, at the very least, we don’t find this ground-level friction between the idea of ESG and a good fiduciary that you maybe have in other markets. Canada also seems to be leading in terms of environment and climate, and I’m excited to see what comes out of a resource-based economy and developments around energy transition.” Of the other markets pushing mandatory ESG disclosures, Sireklove noted Australia and its considerations around modern slavery and supply chains.

Common to all the markets they work with, some pension plans are further along in ESG implementation than others, said Sireklove, adding that she often sees two types of hurdles. “The first is a tendency of some investors to think too narrowly about financial materiality and ESG returns. At Parametric, we live on data and we do a lot of quantitative analysis. Yet I’m surprised at how often even very thoughtful investors want to run a back test on something ESG and then make consequential decisions around incorporating ESG on the basis of that alone.” That’s a narrow view that ignores the benefits of active ownership, she said. “If you lift market beta, you can't easily measure the counterfactual. In other words, we can’t measure what would have happened had we not voted or engaged with a company. That doesn't mean it's not worth doing or not beneficial for long-term returns.” It also can lead to naïve backtests where investors use limited data, for the sake of having some sort of tangible result, and may end up with results influenced by unintended factor bets and they don’t deliver a clear story around the impact of ESG incorporation.

The second hurdle is confusion over ESG data and ESG opinions, she said. “If you think about familiar financial metrics such as a company's debt to capitalization ratio or their gross margin, that's data. That doesn't tell you if it's undervalued, if it's a good company to invest in, if it will outperform its peers. You need the investor to add that value, to have an opinion on what the data means. It’s really no different for ESG. If you know the carbon emissions, or if the company has an appropriate labor policy, that is data. But it doesn't tell you about the company’s intrinsic value or whether it’s worth investing in and of itself. That's where you need an opinion. ESG scores are more like opinions, not objective data. Investors do have different opinions, and that’s why you can see such different ESG scores for a given company. But it's important to distinguish those kind of subjective ESG opinions from absolute metrics that describe companies in a factual way.”

Looking at ESG through the lens of risk management in ESG, Parametric takes a total portfolio approach. “At the total portfolio level, we look at ways we can combine custom ESG incorporation with our liquid alternative volatility risk premium strategies, write options and calls on that to de-risk at the portfolio while still trying to get equity-like returns. You can still do the ESG incorporation on the equity side and think about volatility risk capture. That's a very different view than, say, if you're evaluating individual securities,” Sireklove said.

“In terms of what’s next, we’re very interested in the combination of passive investing and ESG. That seems to be part of an ever-growing interest in stewardship which fits well with passive investing, and it fits with active investing as well,” she said, adding that the role of ESG benchmarks will continue to be a vibrant area of focus. Sireklove also sees a potential inflection point around trying to standardize ESG data and disclosures, with the sustainability accounting standards board, or SASB, developments.

This sponsored advertorial is published by the P&I Conferences Group, a division of Pensions & Investments. The content is not produced by the editors of Pensions & Investments and www.pionline.com and does not represent the views of the publication or its parent company, Crain Communications Inc.