After a bit of help, ESG ready to make even greater gains

ESG investment by institutional asset owners has made impressive gains in recent years, and is poised for even more, thanks to new strategies and measurement tools, and a boost from regulators.

ESG investing among institutional asset owners jumped 61% between 2012 and 2014, according to US SIF - The Forum for Sustainable and Responsible Investment, Washington.

By early 2014, US SIF found, institutional assets in environmental, social and governance strategies in the U.S. reached $4.04 trillion. Of that $4 trillion, public pension funds and other non-corporate institutional asset owners accounted for $2.7 trillion, with corporate asset owners coming in second, at $758 billion.

Breaking that down by type of asset owners shows a wide disparity. A 2015 survey by Callan Associates, which found a 35% ESG adoption rate among asset owners with more than $20 billion in assets, showed foundations with the highest rates of adoption at 39%, followed by endowments, 37%; public pension plans, 27%; and corporate retirement funds, 15%. The differences grew even wider between corporate retirement plans, with ESG use in defined benefit plans at 7% and in defined contribution plans, 24%.

US SIF officials attribute much of the growth to more ESG-factored investment choices being offered by money managers, whose ESG assets under management tripled in the two-year survey period. While many money managers cited client demand as the main reason, they also said ESG factors helped them fulfill a mission, improve returns and manage risk.

US SIF surveys asset owners every two years; results from the 2016 survey, due out in November, should show equally dramatic increases, US SIF officials said.

One factor that many observers expect to influence the 2016 numbers positively is a recent change of heart at the Department of Labor about whether pension fund fiduciaries may consider ESG factors in their investment decisions. In October, Labor Secretary Thomas Perez unveiled guidance aimed at correcting a 2008 interpretive bulletin that he said “unduly discouraged plan fiduciaries. ... Changes in the financial markets since that time, particularly improved metrics and tools allowing for better analyses of investments, make this the right time to clarify our position.”

Under the new guidance, fiduciaries may take ESG benefits into account as “tiebreakers” when investments are otherwise equal, and consider them as more than just tiebreakers when ESG factors have a direct relationship to economic and financial values.

“It definitely will make a difference, said Meg Voorhes, director of research for US SIF, who believes the tone of the 2008 guidance — “somewhere between ambivalent ... and prickly” — scared away many plan sponsors. “If you were a fiduciary, you just wouldn't have gone done that path.”

That could be particularly true when it comes to environmental concerns, said Ian Lanoff, a principal with Groom Law Group in Washington and former Labor Department official. “The DOL recognizes the change in the way investment experts now view environmental issues as legitimate risk/return factors which are incorporated into prudent analysis. You might say the DOL promoted the "E' out of the same category as "S' and "G,'“ said Mr. Lanoff.

Large asset owners active in ESG investing have since turned their sights on other regulators. Despite 2010 guidance from the Securities and Exchange Commission on how companies should disclose risks related to climate change, investors — including the $178.3 billion New York State Common Retirement Fund; the New York City Retirement Systems, with combined assets totaling $155.1 billion; and the $90 billion North Carolina Retirement Systems, Raleigh — are pressuring the SEC to require better corporate disclosure of material risks.

ESG investing is a priority for North Carolina Treasurer Janet Cowell, the pension fund's sole trustee. “Corporate governance is an especially important task for institutional investors ... because holding companies accountable for maximizing their value generates investment returns over the long-term,” said Ms. Cowell.

“Boards and management in today's markets are often too reactive to short-term signals and pressures,” said New York City Comptroller Scott M. Stringer. “We want to ensure that we have boards that are effectively overseeing strategy and risk management for the long term.” Mr. Stringer is fiduciary for the New York City Retirement Systems, which consists of five city pension funds with total assets of $162.9 billion.

The investors are pushing themselves as well.

At its January retreat, members of the investment committee of the $291.2 billion California Public Employees' Retirement System, Sacramento, said they will vote on a new ESG plan for engaging external managers and public companies by August. In the meantime, investment staff on CalPERS' real estate, private equity, fixed-income and equity investment teams said they are surveying external managers on how they integrate ESG into the investment process.

North Carolina already has partnered with Duke University to assess environmental risk in the pension fund's real estate holdings. Now, Ms. Cowell is encouraging investment staff to have “long-termism” discussions with money managers and consultants and to compile peer research on ESG investment approaches. By 2017, the plan is to benchmark best practices and develop a policy on ESG governance, risk management and asset deployment.

TerriJo Saarela, director of corporate governance for the State of Wisconsin Investment Board, Madison, told a gathering of institutional investors in March that where the board once was more reactive to environmental events, for example, “an internal group of both investment and governance staff realized that some of these (criteria) should be part of our day-to-day analysis.” When staff initially got a slim response from the companies in the board's portfolio, “we decided we should really include these in our engagements.”

It's easier for SWIB — which manages 64% of the Wisconsin Retirement System's $89 billion in assets internally — to integrate ESG into the investment decision-making process, because of the amount managed in-house. But officials now want to develop a way to measure the impact. “As it becomes more of an investment theme, and comes up in the investment committee, eventually we'll get to some more specific measures,” Ms. Saarela said.

The Wisconsin board oversees $97.6 billion in total assets.

One badge of distinction in ESG investing is signing the United Nations Principles for Responsible Investment. Tim Barron is chief investment officer of Segal Rogerscasey, a firm that is the result of a merger of two of the first investment consulting firms to sign onto the principles.

Before the global financial crisis set it back, ESG was gaining traction in the U.S., said Mr. Barron, who is based in Chicago. In the past 24 months, “it has become much more front burner” again, he said. “There are lots more conversations that ESG factors matter. It's not just neutral; if you don't focus on ESG, you might be actually hurting yourself.”

Mr. Barron also credits the analytics and screening available through indexes offered by MSCI Inc. and FTSE Group, which allow mixing and matching of environmental, social and governance criteria. “They are extremely versatile,” he said.

While most retirement plan executives outsource selection of ESG products to the money manager, “owners should verify. ESG is rising to the point where it's a question you should ask,” said Mr. Barron. “Clients make sure we are talking to our managers. Almost every asset manager now checks the box that says "we care'. In effect, we are the truth squad.”

Acadian Asset Management LLC, a Boston-based global money manager with $69 billion in assets under management, was the first quantitative manager to sign on to the U.N. principles, said Asha Mehta, a portfolio manager at Acadian who directs responsible investing. She said U.S. institutional asset owners are where their European and Australian counterparts were 10 years ago. “I wouldn't be surprised to see more (implementing ESG). Today, we are talking about seeing it in terms of improving returns,” she said. One challenge she sees in the U.S. is how ESG is defined. Along with a holistic approach, she sees segregated mandates becoming more common. “Where the industry is going now is, which of these factors is likely to help with predicting risk? Today, I am seeing a focus on reporting and then risk,” said Ms. Mehta.

Investment consultant Cambridge Associates LLC formed its mission-related investing group eight years ago, starting with 10 client foundations. Today, it has had 150 inquiries from all types of asset owners, with roughly half making some commitments, said San Francisco-based group leader Jessica Matthews. Some of it is peer pressure, she said, because “asset owners always want to know what other asset owners are doing.”

While interest used to be more often from foundations, Cambridge consultants have been hearing lately from public pension funds, where staff “have been putting a lot of thought into this,” and other retirement funds and universities, where issues important to millennials hold some influence, she said.

Sponsors of defined contribution plans “are hearing a lot from millennial participants that want those options,” agreed Ms. Voorhes of US SIF.

Erica Wolf, a managing director with Rocaton Investment Advisors, Norwalk, Conn., sees some defined contribution plan sponsors interested in ESG but struggling with adding it as a separate option as they try to pare choices for participants. Rocaton, which created its own questionnaire to gauge how existing managers consider — and follow — ESG factors, is helping clients get more comfortable with ESG offerings, said Ms. Wolf , who expects a new fund metric tool being offered by MSCI to play a key role in moving clients from interested to ready to invest in ESG.

One noticeable trend recently “has been this notion of integrating ESG into a total portfolio basis, not as a niche or just a portfolio manager or two,” said Ms. Matthews of Cambridge Associates. “Not everybody is taking that into consideration in their portfolios, but everybody is having that conversation.” As money managers come back with track records, there will be more. “I expect to continue to hear from investors who want to thoughtfully integrate ESG more.”

See SIF's downloadable guide to ESG integration approaches.