With the world facing pressing environmental and resource challenges, asset managers must decide on what their environmental, social and governance strategies are, as this is part of a fiduciary duty, the author of this article argues.

Regardless of what one thinks of ESG practices and philosophy – some might think, like the late Milton Friedman, that the primary focus for business is to maximise shareholder return – this area is now a fact of commercial life. With this in mind, Valeria Dinershteyn from Kempen Fiduciary Management, part of UK-based Kempen Capital Management, takes a look at the fiduciary implications of the ESG area. The views of the author are not necessarily shared by this publication but its editors are pleased to share these insights and invite readers to respond.

Cancer foundations investing in tobacco companies, governments banning the use of cluster munitions and yet financing their manufacture, FIFA’s corruption scandal – these are all clear breaches of fiduciary duty: the broad responsibility to keep the interests and values of the client at the heart of every decision. The root cause of such embarrassments can often be traced back to a systemic lack of integration of ethical, social and environmental values. We believe embedding environmental, social and governance issues as an integral part of fiduciary duty can help investors tackle such challenges as it ensures that sustainability issues are front and centre in our investment decisions.

The trend towards responsible investment has sparked a great deal of debate in the world of finance. Pension funds, family offices, asset managers, and other investment organisations across the spectrum have now seemingly embraced the merits of integrating ESG issues into their investment process. Indeed, more than 1,500 organisations have to date signed the Principles for Responsible Investment (PRI), a set of guiding principles for incorporating ESG issues into investment practice (1). Together, this collection of organisations represents more than $62 trillion of assets, and includes actors with motivations ranging from contributing positively to future generations, to mitigating long-term risks and enhancing reputations as investors.

Based on these numbers, we might assume that investing responsibly is a fundamental and widely accepted part of fiduciary duty. But is that really the case? Looking at today’s investment landscape, has the debate led to actual progress? Or is all the positive talk distracting us from the true reality of the state of play?  

The link between ESG and fiduciary duty
At Kempen, we strongly believe that embedding ESG factors in decision-making is a fundamental part of the fiduciary duty of investors and key to the future development of our industry. Ultimately, it is a way of seeing the big picture and consistently applying prudent principles while making investment decisions. 

However, this approach is not fully shared by all within the finance industry. Despite extensive research attesting to the importance of ESG to long-term value creation, less than 1 per cent of the total capital of the 15 largest US public pension funds is allocated to ESG-specific strategies (ESG-screened solutions, active management with ESG-insight, etc.) (2). 

If you look a little deeper, it seems short-termism persists in the financial markets. Companies and investment managers often remain squarely focused on meeting quarterly financial targets.

In addition, the market can be tinged with misconceptions surrounding fiduciary duty, with some firms struggling to fully accept ESG issues as an integral part of that duty. Yet we live in a world where financial and sustainability issues are becoming ever more tightly interlaced. By 2050, it is estimated that the world will need to provide for as many as 9 billion people against the backdrop of diminishing land, water and natural resources, whilst battling such existential and fast-approaching issues as climate change. In such a world, financial performance and sustainability are absolutely interdependent. 

On top of short-termism and misconceptions, governmental bodies seem to be playing catch-up to investor initiatives and are not always supportive of the changes needed to convince the laggards. Take, for instance, the UK government in 2015 rejecting the Law Commission’s clear recommendation that ESG should be taken into consideration while making investment decisions. This was seen as a step backwards and the government’s acceptance of the status quo. 

However, it is not all doom and gloom – there are good examples of government involvement as well. The French government has obligated asset owners and managers to report on their carbon footprint (3). This is an example of the “push” side of the push-pull movement of the industry towards ESG integration.

The pull side is also gaining traction thanks to voluntary actions by ESG trailblazers. However, in order to really cement ESG’s position within fiduciary duty, the investment community as a whole needs to embrace the work on the topic of responsible investment carried out by academics, scientists and organisations such as the UK Sustainable Investment and Finance Association (UKSIF), the PRI and the Kay Review.

Hundreds of articles and academic research papers have been written on the subject of incorporating the ESG criteria into investment decisions. For a flavour of the reports on the topic of sustainability, please see the research by CalPERS who have analysed over 800 academic studies (4).

The underlying purpose of this review of evidence presented by CalPERS is to create a searchable database of over 700 academic studies on sustainability factors spanning four decades of research, which
will allow us to examine the ultimate impact of these factors on investment risk and return.

What could happen if nothing changes?

What if financial institutions continue to neglect ESG factors? Is it just a matter of some poor publicity for asset managers? In fact, the consequences can be dire and the material risks to economic value are clear to see.

Stories of the Enron fraud scandal, the Volkswagen emission scandal, BP and the Deepwater Horizon accident; Mossack Fonseca and the Panama Papers; Toshiba’s accounting scandals; Valeant’s secret division; Martin Shkreli’s HIV drug price hikes; Exxon Mobil’s deliberate misleading of the public on the topic of climate change. The list goes on and on. Not taking the time to properly assess a company’s risk profile can lead to the names of investors and pension funds appearing on newspaper front pages, and ultimately destroy the value of the holding or damage the reputation of the asset owners. All of these are clear examples of how affiliation (even if only perceived) with ESG issues can hurt the reputation of the investor and financial performance of funds. Incorporating ESG into investment decision-making provides no iron-clad guarantee that you will be spared such ignominies, but it does logically decrease the probability of them occurring. 

What next?
Simply agreeing on the importance of ESG value drivers is not enough to live up fully to our fiduciary duty. Our investment philosophy is based on a strong conviction that ESG risks and opportunities directly affect the long-term performance of a business and hence are an inseparable part of our fiduciary duty. In other words, we firmly believe that companies must be in tune with society’s needs in order to continue operating successfully in the long term. 

‘Our favourite holding period is forever’
Though the saying was made famous by Warren Buffett, we too believe in long-term holding periods. A preference for near-term results creates an atmosphere where tomorrow, and each day after, receives less attention. Investing for the long term, with a holistic understanding of fiduciary duty, shifts this focus and allows investors to engage with the companies in which they invest on ESG issues instead of simply selling the stock. Value creation takes place through a dialogue with firms, referred to as engagement, by realigning management strategies for a sustainable economy (5). 

At the heart of our investment philosophy is an explicit consideration of material ESG risks for every industry and business. This can be done by both investing responsibly and creating a rigid system of review to check that external managers are integrating ESG issues. We consider it vital to assess the ESG performance of our external managers both during the rigorous due diligence process and going further in the monitoring process with the manager.

Time of change
The world is changing. We are facing global economic challenges which can only be tackled effectively together. No part of society will be left unaffected and the financial sector is no exception. To facilitate forward-thinking decisions on behalf of clients in a challenging investment landscape, our society expects full transparency from financial institutions regarding their responsibilities. PRI’s fiduciary duty statement – which Kempen supported – represented a milestone on the path towards a holistic approach to investment decision-making. We strongly believe that owners and managers of financial capital have a significant role to play in supporting enterprises which improve and protect the sustainable economy. This approach is rooted in our more than decade-old European sustainable small-cap strategy and a newly developed approach of adopting a high active share long-term portfolio, called Focusing Capital on Long-Term (FCLT) (6).   

Motivation for incorporating ESG into fiduciary duty may range from contributing positively to future generations, to mitigating long-term risks and enhancing your reputation as an investor. In our opinion, a responsible asset owner needs to know the holdings in their investment portfolio and understand the ESG risks and opportunities of these holdings.

Based on continuous ESG screening and dialogue with companies in the portfolio, as asset owners you need to decide on your ESG strategy: do you exclude potential controversial companies or start a dialogue to encourage positive change? Whatever you choose, be transparent about it and report your policy and actions to your stakeholders. It sounds simple, and actually it is. 

Now it is time for the industry as a whole to act. Will you join us?

Footnotes

1. https://www.unpri.org/,
2. http://www.mckinsey.com/industries/private-equity-and-principal-investors/our-insights/sustaining-sustainability-what-institutional-investors-should-do-next-on-esg
3. https://www.ipe.com/countries/france/france-aims-high-with-first-ever-investor-climate-reporting-law/10011722.fullarticle
4. https://www.calpers.ca.gov/docs/governance/Archive/investments/siri-database-of-academic-studies.pdf
5. http://www.shiftto.org/paper---focusing-capital-on-the-long-term-by-barton-and-wiseman/
6. http://www.kempen.nl/asset-management/investment-funds/kempen-sustainable-european-small-cap-fund-a/?langtype=1033