There are a multitude of factors which affect the long-term success, or otherwise, of a company and not all of them appear in a balance sheet or cashflow statement. Investors have come to recognise that managers who understand and address the broadest possible range of issues facing their company are much more likely to be successful in the long term. This broader “sustainable” investment agenda encompasses a number of approaches that have been a small but steadily growing ‘niche’ market for many years [including socially responsible investing (SRI) and ethical investing (EI)] but has much more mainstream relevance and appeal than these ‘screened’ approaches. Indeed, it can be argued that long-term investors who ignore environmental, social and governance (ESG) issues are unlikely to identify the long-term winners and losers given the likely global developments over the coming decades.
As naturally long-term investors, pension fund trustees have most need to understand and grasp such developments – however this comes at a time when the pressures, demands and complexity of issues facing pension trustees have never been greater. In this light, pension funds need confidence that these broader considerations are consistent with their requirement to act in the best financial interests of members. Backed by research, it is our view that pension funds would be acting in the best interests of their members if they were to implement various elements of a sustainable investment programme. Naturally, some elements would be more suitable than others as each pension fund is different and governance levels* vary considerably.
In essence there are four aspects that funds can consider: voting, engagement, specialist ‘sustainable’ investment managers and macro factors but funds will need to assess their governance levels before embarking on any of these.
Voting: The most fundamental element of a long-term investment approach is that share owners should take their voting rights and responsibilities seriously. Unfortunately, from our experience, fund managers in general do not take this aspect of their role as share owners as seriously as if they were in fact the owner and not just the agent. They often lack the structures and resources (both human and financial) required to process, evaluate and instruct votes effectively and in particular we question whether an accountable and transparent process that enhances value to shareholders is always in place. Since all significant issues should be subject to shareholder approval, voting is a key tool in the scrutiny process and without effective action in this area a fund manager can not claim to be taking a long-term interest in a company’s development.
Engagement: Voting, while an essential and fundamental part of a share owner’s role, is essentially a ‘reactive’ activity. We believe that pension funds, especially large ones, are among the most influential investors around and should be able to add value to a broad market portfolio by proactively engaging with poorly governed firms to encourage better governance. We do not believe that this is a zero sum game whereby improving the governance of poorly governed firms erodes the price advantage of better governed firms. Rather, improving governance can unlock profits and cash flows for shareholders that might otherwise be wasted or misused. There are a number of ways of implementing this aspect, one being via an engagement overlay whereby a single specialist manager is given a remit to engage with investee firms across all the equity assets of the pension fund.
Sustainable investment management: Governance issues are not the only ‘extra financial’ issues which can influence the future outcomes of a company. Social and environmental issues can also have a significant impact and we believe that fund managers that take account of this broad range of ESG issues in their investment decisions are more likely to be able to identify long-term winners and losers.
This is not just about investing in firms that are leaders in the development of, for example, sustainable energy. It is also about understanding how litigation risks affect the valuation of tobacco firms; how carbon-trading costs will affect European cement companies; how microfinance in developing countries can transform banking arrangements in remote communities. Certain fund managers are already devoting significant resources to researching and understanding these issues, and are reaping the benefits in controlling risks and exploiting opportunities in their portfolios. Pension funds can enjoy these benefits too, not just in equities but in a range of asset classes, simply by appointing managers that understand the issues, and have the appropriate skill and resource to deal with those issues effectively.
Macro factors: We believe that so-called macro factors such as environment, demographics and energy will have a big influence on the performance and risk of individual companies and global equity markets in the future. These factors will develop over the coming decades and it is quite possible that in due course all equity managers will have to adopt a sustainable investment approach, taking into account these macro factors, to some degree. Clearly, it is impossible to predict exactly how this will play out over the coming years, but undoubtedly, as with every new and developing trend, those fund managers that are aware of these factors, and are positioned to exploit them now, will enjoy particular advantages in these early stages.
Investors are beginning to appreciate the impact that extra-financial factors can have on long-term performance. This is particularly important as we enter a period in which large-scale external macro factors are likely to have an increasing influence on markets. We believe that pension funds can exploit these opportunities in a range of ways, depending on the particular circumstances and governance level of the fund.
Tim Currell, senior investment consultant at Watson Wyatt.
*Governance levels refer to the resources, time and experience available to a pensions fund trustee body that can be applied to investment issues.
