Ask a dozen institutional investors how they approach ‘sustainable investing’ and you’ll likely get a dozen different answers. What will be consistent, however, is their understanding that successful investing in today’s world requires at least a consideration of environmental, social and governance factors.

Sustainable investing incorporates ESG factors to generate long-term competitive returns and deliver positive environmental or social impact. The approach can range from selecting or excluding companies based on a variety of ESG criteria all the way to an impact strategy, which invests in companies to achieve specific sustainable outcomes.

The scope of sustainable investing has moved significantly beyond the equity markets. Investment managers across many other asset classes are adopting ESG factors to build the strategies and products that asset owners are increasingly demanding.

Sustainability in Institutional Investing

As sustainable investing continues to surge among institutional investors, considerations of environmental, social and governance factors in selecting investments have expanded beyond equities to other asset classes. The spectrum of ESG integration approaches has also widened significantly to include impact investing and thematic investing, which aim to achieve target returns along with specific environmental or social outcomes. This webinar will bring you up to speed on some of the latest strategies in sustainable investing across different assets and will help demystify how asset managers select and monitor companies and funds across ESG metrics.

Featuring

Megan Reilly Cayten

Sr. Investment Manager

HSBC Pollination Climate Asset Management

Mahesh Jayakumar

Research Analyst - Fixed Income

MFS Investment Management

Mary-Therese Barton

Head of Emerging Market Debt

Pictet Asset Management

Wednesday, November 10, 2021

2:00 p.m. ET

Register Now

While there are myriad studies showing the value of sustainable or ESG investing for equity investors, there has been far less research on the fixed-income side until recently, said Mahesh Jayakumar, CFA, FRM, fixed income research analyst at MFS Investment Management. The firm’s fixed-income team has long been committed to ESG integration not only due to the materiality of ESG risk factors, but also opportunities on investment returns.

“We are an active manager with the goal of generating returns through various phases of the business cycle,” Jayakumar said. “Our goal is to provide a [competitive] return to our clients, and to do that, we need to think about both ESG risks and opportunities in our investment thesis. For us, ESG is not about excluding certain industries or sectors, but an integrated part of our mainstream investment process.”

ESG factors must be a focus for any institutional fixed-income investor with a longer time horizon who aims to achieve returns that will survive macro regimes and business cycles over time, Jayakumar said. But while many investors think of ESG factors impacting an asset over the long term, there can be short-term implications as well.

Read: Our approach to integrating ESG in Emerging Market debt investing

“ESG issues can become controversies, and controversies can become headline risk or bring about reputation risk for a company,” he said. Such events can cause, at a minimum, a temporary slide in a company’s stock price or bond spread. For that reason, MFS’ fixed-income team frequently discusses and encourages progress on ESG factors with issuers.

The imperative of ESG considerations is apparent on the corporate side as well. “You’re not meeting your fiduciary responsibility if you’re ignoring ESG factors,” Jayakumar noted. “If you’re a company that has incurred, or is in the process of incurring, environmental litigation or is mired in a social or governance controversy, you’re not going to be able to move forward until you get your house back in order.”

Some may not think of fixed-income managers as being able to engage with companies, he pointed out, but they may have several opportunities for continued dialogue with both companies and governments who meet with investors during road shows to raise capital. As issuers come in to raise new capital or seek refinancing, fixed-income managers like MFS have an opportunity to engage with companies on specific ESG issues.

“When you meet with a bond issuer on a roadshow on their maiden issuance, you ask them questions not only about their financial status, profitability and business strategy, but you also seek information about their sustainability profile,” Jayakumar said. “For new issuers, we want to understand their sustainability journey, and for incumbent companies, we want to make sure that their position has not worsened on any of those [ESG] factors.”

Jayakumar said he also sees growing opportunity to invest in bonds that fund projects with a direct sustainable impact. “In the case of green bonds or other thematic bonds, we see companies that are going to directly use the proceeds on an environmental project that aims to improve energy-efficiency or build a new renewable power plant,” he said.

 

Sovereign debt managers are always focused on the ability of a country to pay its debt, and ESG factors have become an increasingly important part of making that determination, especially in the emerging markets.

“Emerging markets are at the forefront in terms of the impact of climate change because the biggest change in temperature will be around the equator and, particularly, in some of the smaller and poorest markets in the world,” said Mary-Therese Barton, head of emerging market debt at Pictet Asset Management (Pictet AM). Her team has focused on ESG factors, particularly as they relate to the United Nation’s Sustainable Development Goals, for many years.

The presence of natural capital — natural assets such as soil, water, air and living things — and biodiverse environments also makes those countries key allies in fighting climate change and decarbonizing economies, she noted.

Read: Rebirth of an asset class

Barton said that the ESG focus of these economies has become even more important in recent years as the maturity profile of bonds has lengthened, with 100-year paper becoming more common. “If there’s any asset class where these long-term issues should be considered, we think it’s in emerging-markets sovereigns, particularly with regard to policy and sustainability.”

Pictet AM’s fixed-income team has ramped up its engagements with issuers on sustainability issues. There has been a spike in emerging market sustainable bond issuance this year (see Pictet AM’s chart). For the emerging markets team, the discussions include meetings — with both corporate issuers and sovereign issuers — on a wide range of topics, from investing in human capital development to reducing their fiscal deficit.

“We believe it’s important to be discussing these issues of long-term sustainability with the issuers themselves,” Barton said. “That’s becoming increasingly possible with the help of the World Bank and [via] roadshows. It’s very much a topic that debt management officers expect you to touch upon.”

Pictet AM sees plenty of opportunity for fixed-income investors to have ESG-integrated portfolios as the emerging market countries, like the rest of the world, look for ways to transition to greener, more sustainable economies, particularly in the post-COVID-19 environment, said Burton. “It’s the classic interaction in any EM debt investing, with the macro themes increasingly developing with a lens on climate, environment and social issues [and] with idiosyncratic country trends to identify those opportunities in the portfolio.”

With fixed-income investors focused on the long-term, that also means evolving the due diligence process to incorporate many more factors — including ESG issues, said Adriana Cristea, investment manager in emerging debt at Pictet AM. It’s important for investors to understand the links among ESG-related policies, their impact on a country and that country’s ultimate ability to pay back its debt.

Alongside institutional investors’ drive toward sustainable investing in the public markets, private venture strategies focused on climate and energy are attracting investors who want to meet specific ESG-related portfolio objectives and deliver direct impact.

One such specialist is the joint venture between HSBC Asset Management and Pollination Group named Climate Asset Management. The firm is focused on ‘natural capital,’ or nature’s assets, such as forests and farms. The strategy is investing across the globe in regenerative agriculture, sustainable forestry, biodiversity and real assets that generate carbon credits, said Megan Reilly Cayten, senior investment manager at Climate Asset Management.

 

Climate Asset Management investors are increasingly recognizing the importance of protecting natural resources, both because the future of the earth depends on doing so and because they’re a potential source of financial returns, said Cayten. “Our intent is to establish a series of natural capital strategies that invest in a diverse range of activities to value, preserve, protect and enhance nature over the long-term” and that can deliver both financial and impact returns while reducing risk for investors, she said.

The firm’s ESG framework emphasizes that it “do no harm,” while its impact framework focuses on “doing good” in a way that’s core to its investment thesis. “So, in addition to financial returns, we deliver measurable, positive impacts on ecosystem services and communities from the real assets that we invest in and manage,” said Cayten. (See chart on the problem and the opportunity in nature and climate.)

“Our intent, for example, is to demonstrate that regenerative practices in agriculture are consistent with long-term financial returns,” Cayten said. “It goes beyond sustainability and into impact. ESG is just fundamental to long-term risk management.”

Diversification is an important part of the strategy. “Diversification helps reduce risk because we’re not dependent on any one geography or sector or type of asset. Our internal analysis shows that including natural capital in a diversified portfolio can reduce portfolio volatility, act as an inflation hedge, and is uncorrelated with equities and investment grade bonds.”

HSBC’s joint venture, Climate Asset Management, takes a holistic approach to managing its assets. When managing land assets, for example, it looks for ways to make that land more resilient, such as potentially changing the use of the land or changing the practices used in farming it, Cayten explained. This process can minimize the risk of flood or fire while also increasing productivity and, ultimately, make the land asset itself more valuable.

“All the investment in our natural capital strategy needs to generate both financial and impact returns. Our commitment to both means [that] we can approach the investable universe from both directions, interrogating how a commercially viable investment opportunity can generate more impact and how an impactful ecosystem-restoration opportunity can generate more financial returns,” she said.

It’s far less common today for us to meet naysayers about the importance of thinking about sustainability for emerging market debt investing,” said Barton at Pictet Asset Management.

As client engagement around sustainable investing has skyrocketed in recent years, ESG themes begin at the request-for-proposals stage, when an asset owner begins engaging with Pictet AM, and continues in subsequent engagements, often with detailed conversations about the firm’s sustainable investing approach at each stage, she said. Asset owners are very engaged in understanding how best to invest in emerging markets in a sustainable way, including product structure and how each product addresses sustainability challenges.

To meet client demand for a focused sustainable strategy in the sovereign debt space, Pictet AM launched the Sustainable Emerging Debt Blend strategy, which combines hard currency and local currency bonds. The strategy uses an ESG benchmark and then layers in additional ESG considerations to reallocate capital to countries where it sees positive sustainable trends, Barton said.

“It’s still early days, and asset owners are trying to understand how to best think about an ESG sustainable lens for emerging sovereigns and even for developed sovereigns,” she said. “We’ve passed an important mark in recognizing that it’s possible to do so with allocators.”

Given the nuances involved in such investing, asset owners typically want to allocate toward active managers. “There are a lot of gray areas, and discretion and a considered approach is important,” Barton added. “A focus on momentum and trends is really important in terms of the spirit of sustainable outcomes for this asset class.”

Many asset owners are in the educational stages when it comes to learning about natural capital, especially as a long-term, noncorrelated asset to round out an investment portfolio, said Cayten at HSBC’s joint venture, Climate Asset Management.

“We designed the strategy specifically to bring institutional investors on a journey that starts with something that is reasonably familiar, in terms of agriculture and forestry,” she said. “We’ve had really interesting conversations in Europe, and we are just starting to have them in the United States.” The strategy has drawn interest from public pension funds in North America — who appreciate what they see as risk-reduction benefits at a portfolio level — as well as European insurance companies that aim to comply with sustainable finance directives, she added.

One of the driving factors behind the interest by asset owners is a growing appreciation of the risks that nature can put on any supply chain, either due to natural disasters or simply the impact of warmer weather on crops, said Cayten.

A key consideration is that sustainability-focused investors in impact funds, like their natural capital-focused strategy, need to have a longer time horizon, and that is not always the objective for some investors.

“This strategy has a 15-plus-year focus because it takes five years to transition a farm to regenerative practices or 10 years for trees to grow until they’re generating enough carbon to be worth selling,” she said. “Nature doesn’t change on a quarterly basis the way that some [investors] might want it to.”

“Asset owners are doing their due diligence about ensuring that they have chosen the right asset manager who is ‘walking the walk’ and not just ‘talking the talk’ on sustainable investing,” said Jayakumar at MFS Investment Management. His team sees increased awareness among asset owners who are asking more pointed and granular questions about how managers integrate sustainability into their products and processes. Specific queries can run the gamut of ESG sectors and approaches. While some clients are focused on creating a portfolio that reduces carbon emissions with a net-zero goal, others might also be interested in sectors relating to responsible production and consumption.

Whatever the specific ESG sector or issue, Jayakumar said conversations with asset owners are far more frequent today than just a few years ago. Many of them believe that sustainable investing, or ESG investing, aligns with their fiduciary responsibilities (see MFS Compass 2021 chart).

Some discussions with asset owners result in custom strategies where MFS collaborates with an institutional client to build an ESG approach that best meets their specific needs and investment goals. “It’s not about us dictating a particular way of implementing ESG,” he said. “It’s a give and take, in terms of what kind of solution the asset owner may be seeking, and then working with them to help implement it in their portfolio.”

The customization also depends on the type of debt that an investor might be looking to purchase. “The strategies for corporate bonds, sovereign bonds, municipal bonds and securitized bonds are all very different in terms of how you think about ESG factors,” Jayakumar said. “But the base level of due diligence, from a sustainability perspective, always starts with understanding the current state of the issuer’s sustainability profile.”

While measurement and benchmarking of ESG factors has made enormous strides in equities, there are fewer data providers or universally accepted metrics for sustainable investments in the other asset classes, particularly in alternatives and direct investments. With both asset managers and asset owners squarely focused on measurement, progress in ESG data standardization and availability is expected to continue over the next few years.

At HSBC’s joint venture, Climate Asset Management, one of the most common questions from asset owners is how we measure the impact of our portfolio strategy, as there is no obvious benchmark for this strategy. So we aim to incorporate the best data we can find to inform our decision-making and to create a framework for our strategy, knowing that the data and technology are going to keep improving significantly as demand increases.”

The firm currently works with best-in-class operating partners and advisors to create a sustainable development plan for each asset, using science-based targets and then measuring and reporting the asset’s performance against that plan, she said.

“The goal is to make sure that our impact measurement and management framework is aligned with leading standards on impacts and natural capital — and with the global goals that are material to our assets — and then bring those goals down to the asset level to also determine how that asset can contribute to those objectives,” Cayten said. Part of that process involves determining key performance indicators for each asset, with a recognition that the KPIs are likely to be very different for a farm in the American Midwest versus an Amazonian rain forest.

“Natural-capital accounting is quite an intense exercise, but we’re moving toward it,” she said. “We’re not there yet, as an industry, to allow for natural-capital accounting across the board, but I think it’s coming. That’s one way in which the industry is going to evolve.” Over time, she said, better data and policy could enable a market evolution that values ecosystem services and incentivizes sustainable and regenerative practices.

Of course, the firm measures financial returns as well. “If we were to have an impact-forward investment in our portfolio that sacrificed financial returns below our targets, we would fail on our impact objectives,” Cayten said. “We’re aiming to deliver blended financial performance and impact performance at a portfolio level.”

Jayakumar said the MFS fixed-income team looks at all available data sources when making investment decisions, including data from companies, governments, nongovernmental organization reports, third-party vendors and ratings agencies.

“With all that data, we pay attention to the underlying information and the raw metrics that are directly about the issuer, as opposed to an aggregated score,” he said. “We need to dig deeper” than what the aggregate shows.

In parsing the data, MFS carefully aims for quality over quantity, looking for best-in-class data for each of the ESG pillars. Even after it has invested in an issuer’s bonds, the fixed-income team continues to look at performance across all the material ESG metrics. “At a minimum, there’s a yearly reevaluation in terms of vetting the company’s sustainability profile, if not more frequently. Once you’ve started it, you keep moving the process forward,” Jayakumar added.

Read: Why We Believe Active Management Is Essential to Sustainable Investing

That re-evaluation process may also occur over a longer period for some factors, he said. A company committed to reducing carbon emissions, for example, might not show much improvement month to month but should be able to prove that it’s moving the needle from one year to the next.

Jayakumar said he also expects to see more standardization of data and data sources over the next few years. “You’re already seeing harmonization of benchmarks and of measurement standards …and you’re going to see even more of that,” he said, pointing to the sharp increase in the number of public companies releasing annual sustainability or ESG reports over the past few years. “This is a fantastic development for investors like us to start or continue the process of vetting a company on its sustainability journey. You are able to get sustainability information that you need directly from the company. What are its [sustainability] aspirations and where is it going?”

When it comes to sustainability data on sovereign debt, there’s still a lot of room for improvement. Pictet Asset Management (Pictet AM) often turns to partners on the ground in emerging market countries for help gathering reliable and accurate data, said Barton. The firm feeds that data into its proprietary scorecard, which is built around the United Nation’s Sustainability Development Goals and aligned with the firm’s vision of sustainability via the ESG pillars. It then uses additional exclusions and analysis to surface the best investment ideas for its strategy, she explained.

“We put a lot of work into selecting the indicators that we want from our data providers and thinking about how to combine and weigh them, and so on,” said Pictet AM’s Cristea. “Obviously, on the environment side, you have carbon emissions, but we also look at air quality, deforestation trends, water security and other indicators that allow us to understand how a country is using its natural resources and how sustainable that is.”

Pictet AM’s ESG Scorecard also accounts for other factors, such as education, healthcare, gender equality and economic inequality, and how the country uses and invests in human capital.

 

“The focus for ESG investors has typically and more naturally fallen on ‘E’ because it’s more measurable,” Barton said. “But as we’re reaching a post-COVID landscape, the importance of investment in education and in health capacity is going to increasingly be recognized as a key pillar.” (See ESG scoring example above.)

Gathering the necessary data has gotten easier over time, Cristea noted, allowing Pictet AM to focus its efforts on correctly interpreting the scores and evaluating policy trajectories. It revises the scorecard as necessary to account for new information or new sources of data that become available.

“I hope that we will start to get more standardized data from sovereigns in terms of what funding is going where, and how it’s impacting that country’s growth model and long-term sustainability,” Cristea said. “We’re looking forward to a lot more transparency and better reporting of this broader set of factors that influence economies and emerging markets more broadly.”

Emerging market governments themselves are starting to realize that the more data they can share, especially if it’s telling a positive story, the more interest they’ll get from fixed-income investors, said Barton. “Even from some of the most unlikely suspects, you might now see a couple of pages with reference to participation in the workforce, the greening of the economy or decarbonization,” she said. “It’s really setting the stage to allow us to have these discussions with them [on sustainability].”