With growing global awareness of sustainability issues, our clients are increasingly seeking out Socially Responsible Investment (SRI) funds. Aegon Asset Management applies its RI Policies and ESG standards across all investments and for most of our clients this meets expectations. Some of our client groups would like their moral standards or ethical beliefs specifically reflected in their investments. SRI funds are a good way of meeting these specific client needs.
SRI funds typically narrow the investment universe by excluding companies involved in controversial activities (negative screening) or overweight investments in companies that outperform other companies in terms of ESG (positive screening). Over the past year, portfolio managers at various Aegon Asset Management units have worked to develop new, or update existing, SRI funds. To better understand the challenges and opportunities in this area we spoke with a number of colleagues working on these funds.
SRI funds typically narrow the investment universe by excluding companies involved in controversial activities or overweight investments in companies that outperform other companies in terms of ESG .
The customer is king
Marianne Oomkes, Senior Account Manager at TKP Investments (a subsidiary of Aegon Asset Management in the Netherlands) was involved in the development of a new SRI fund in 2016 for their client, Stichting Prins Bernhard Cultuurfonds, a not-for profit charity organization. The client specifically asked TKP Investments to tailor its developed world equity allocation into a more ESG-focused product that would reflect their investment beliefs. Marianne feels that capturing the clients’ wishes and appropriately reflecting them in the fund is the biggest challenge in developing an SRI fund. “The long-term relationship with our clients is always our main priority. To develop this product we worked closely with them, by analyzing a number of different indices and advising on fit with their ESG preferences, potential for financial performance, tracking error, and so forth. But the whole process to set up the fund took only a few months from start to finish.”
Capturing the clients’ wishes and appropriately reflecting them in the fund is the biggest challenge in developing an SRI fund.
Ryan Smith, Head of ESG Research at Kames Capital (a subsidiary of Aegon Asset Management in the UK) agrees with this observation, “Kames has a long history of successfully managing negatively screened ‘ethical’ funds in the UK. However, we knew this approach wasn’t necessarily going to resonate with clients in continental Europe, although we felt we could leverage our reputation for corporate governance research and engagement.” Therefore, in developing the new Global Sustainable fund for distribution outside the UK, Kames Capital consulted a number of key clients as part of their market research. Kames also analyzed other funds that were most in demand on the continent and looked at recent academic research linking ESG factors with investment performance.
Sometimes working with ‘the client’ is not straightforward. Roger Wildeboer Schut, of the Aegon Asset Management Responsible Investment team, is working to develop an ESG benchmark for large portfolios of passively managed equities in the Netherlands. “We get feedback that retail clients who invest in the funds would like to have a strong ESG angle to their investments.
But we also observe that only a very small minority of clients switch from the default index funds to the SRI fund that we currently offer, so we are developing an ESG benchmark that will be the default for all these passively managed equities,” explains Roger. The benchmark will apply to a fund range that thousands of individual clients invest in, so surveying them on specific ESG themes like TKP Investments has done with its client, one individual institutional investor, is not an option. Nonetheless, he says, “this creates challenges because we need to ensure that when we make changes to the fund the broad group of clients will welcome the new approach.”
“We need to ensure that when we make changes to the fund the broad group of clients will welcome the new approach.” -Roger Wildeboer Schut, Aegon Asset Management
Lack of ESG disclosure
Ryan identifies the lack of ESG disclosure by companies in certain markets and regions as another hurdle to SRI investments. However, he notes, “Disclosure standards are improving quickly, especially in Asia, and we are firm believers that investing in emerging markets is the right approach as many of the greatest sustainability challenges are faced in these regions. Also, some of the most exciting sustainability solution providers are listed in Asia.”
“The lack of ESG disclosure by companies in certain markets and regions is another hurdle to SRI investments.”- Ryan Smith, Kames Capital
SRI analysts Paul Merle and Benoit Humeau from our French joint-venture partner La Banque Postale Asset Management (LBPAM) had similar findings. LBPAM updated its SRI methodology following its recent merger with Fédéris. Both firms had an existing SRI approach and wanted to create a new best practice based on their combined expertise. Paul led the process and believes there is a size-bias in ESG disclosure, “If you simply look at the ESG ratings you have to conclude that larger companies perform better, but we think often this is because they simply have larger departments to track all kinds of ESG indicators and report on them. Smaller companies sometimes don’t perform worse, they’re just not disclosing it.” In order to reduce the effect of this size bias SRI analysts at LBPAM engage with companies to obtain more than just publicly available information.
“If you simply look at the ESG ratings you have to conclude that larger companies perform better, but we think often this is because they simply have larger departments to track all kinds of ESG indicators and report on them. Smaller companies sometimes don’t perform worse, they’re just not disclosing it.” -Paul Merle, LBPAM
Kames Capital follows a similar approach. According to Ryan, “In trying to build a picture of a company’s ESG performance and journey we use a variety of sources including ESG rating agencies, company disclosures, news and journal articles, broker research, company meetings and our own historical voting data, where we have it.”
Pluses or minuses to performance?
A frequently asked (but still inadequately answered) question about SRI funds is whether they help or hurt performance. Looking at the available academic research on the topic, the consensus now appears to be that “it doesn’t seem to hurt performance, and there may be a slight positive effect on returns.” However, academics also caution about drawing sweeping conclusions for all SRI funds, given that the approaches for the various funds they research differ strongly. At the end of the day it really depends on the underlying ESG approach.
Looking at the available academic research on the topic, the consensus now appears to be that “[SRI] doesn’t seem to hurt performance, and there may be a slight positive effect on returns.”
TKP Investments looked into this question for its client by tracking performance of the index it selected for the fund and found that over a time period from 2007 to 2015 the benchmark of the TKP Investments MM World Equity Index SRI Fund performed as well as the parent index, but with a lower degree of volatility (risk). TKP Investments also looked at the diversification in the index (sector and region), a metric that helps determine performance potential. TKP Investments concluded that with approximately 400 holdings, the MSCI World SRI Index Fund offers sufficient diversification benefits.
Because it has an actively managed fund, the LBPAM approach is slightly different from the TKPI one. Benoit believes that identifying companies and businesses that manage resources responsibly and have high-quality governance will improve long-term performance and reduce reputational and financial risks. According to Benoit, “Our approach sets us up well to understand long-term challenges, we focus on identifying companies and sectors that offer solutions and innovation to the main ESG challenges.”
Identifying ESG momentum
Kames Capital went a step further in analyzing the question about investment performance for SRI funds. As part of the sustainability analysis of companies for its Global Sustainable fund, it classifies companies as ESG leaders, improvers and laggards (the latter being un-investable).
Ryan commented, “For ‘improvers’ we outline the key ESG performance indicators that we feel are important for a company and which we will track going forward to measure their improvement process. There is strong evidence that investing in ESG ‘improvers’ is an effective way of integrating ESG into investment processes. Such an approach avoids the biases that many best-in-class approaches suffer from – such as value, largecap, European, lack of emerging markets – and provides a larger opportunity set. Focusing on ‘improvers’ also fits well with our own experience of working with companies on traditional corporate governance issues as they grow from IPO to full listing.”
Sweat the small stuff
Finally, all of our colleagues working to build SRI funds point to operational challenges, and to the importance of minimizing costs. For instance, TKP Investments had to decide on the most cost-efficient way for the client to migrate from the original world equity allocation to the SRI allocation, while maintaining full exposure to the equity market during the transfer period. Marianne explains how they “decided to do an in-kind transaction for close to the total original equity value, which was then followed by a buy-and-sell strategy in units for the remaining equity value. The second transaction was really used to optimize currency hedges and to determine the desired distribution between both the hedged and unhedged investment fund.”
Roger is also grappling with this issue. As he points out, “Once we apply the ESG benchmark there needs to be a transition where we’re selling securities and buying others on a fairly large scale. Of course this comes with transaction costs, but we want to minimize them – otherwise we could easily erase potential performance benefits from the ESG approach by incurring these transaction costs.” The solution can probably be found in opting for a longer transition period and having trades coincide with rebalancing – the periodic buying and selling of assets that ensures the fund matches with the benchmark.
Next Steps in SRI Funds
All Aegon Asset Management colleagues working on SRI funds are passionate about their product and are enthusiastic about market opportunities, benefits for clients and – last but not least – having an impact through investments. Marianne comments, “The investment fund is subject to economies of scale. We are convinced that as more participants will invest, and assets under management increase, the costs measured in terms of basis points will reduce significantly.”
“The investment fund is subject to economies of scale. We are convinced that as more participants will invest, and assets under management increase, the costs measured in terms of basis points will reduce significantly.”- Marianne Oomkes, TKPI
Paul explains that LBPAM would like to do more to measure how the fund is contributing to global challenges, “LBPAM already discloses some extra-financial and impact indicators for the funds, and LBAPM has also developed tools to publish the performance of SRI Funds compared to their benchmarks on ESG raw data. We also plan to significantly improve on these indicators and extend these activities in 2017.”
Roger is aiming to finalize his project to develop the ESG benchmark for the passive equity portfolio in 2017. “We still have a lot of logistical hoops we have to jump through, and all the departments involved have their questions and requirements. But the portfolio is very large, which makes it all worthwhile. That is why I think our integrative approach works: we make ESG part of the very large portfolios that we manage. It is hard work but in the end you know that the impact will be huge. That is very rewarding.”
Harald Walkate, Global Head Responsible Investment, Aegon Asset Management