ESG Considerations for Investment Manager Selection

One of the most significant events in sustainable finance came in 2020 when Larry Fink, the CEO of BlackRock, the largest asset manager in the world, called for a fundamental reshaping of finance. The reshaping that Larry had in mind was to put climate change and sustainability issues at the center of risk assessment and capital allocation. The letter is a clear warning to company CEOs: climate and sustainability risk is investment risk. As other investors come to this same realization, the implications for asset values and the reallocation of capital could be profound. Changes to capital markets could come much more quickly than the physical impacts for climate change itself given the propensity of capital markets to discount future risk today.

Considering climate and sustainability risk in your company’s capital allocation process is no longer optional. In fact, BlackRock has even gone as far as to state that they will vote against management and board directors of companies that are not sufficiently incorporating sustainability practices into business plans. BlackRock has stated that they expect that sustainability integration will ultimately result in lower investment risk and better market returns. In short, sustainability is the new standard for investing.

Given that companies will face increasing shareholder pressure to incorporate sustainability into capital allocation, enterprise risk management, and standard operating procedures, it is essential to understand the underlying investment drivers for asset managers and how they might consider environmental, social, and governance (ESG) or sustainability risk factors. Clearly, climate-related risk is the most material ESG risk for many industries and sectors, but health and safety, labor management, anti-corruption, and toxic environmental releases are also key issues that must not be overlooked ^[1].

In this thought-leadership series, we look to put you in the shoes of the asset manager. How are investment decisions made? What are the unique implications for various asset-classes? How do asset managers consider investment risk? How is traditional asset management balanced with ESG considerations? These are some of the questions that we hope to tackle. Our goal is to help companies better understand the asset manager process and prepare for the shifting expectations around sustainability integration and disclosure. Those companies that can navigate this fundamental reshaping in finance will be best positioned for growth as the economy transitions to a more sustainable, lower-carbon future.

Introduction

In this thought-leadership piece, we provide the reader with an overview of the investment manager selection process and implications for ESG-investing. Key components of the manager selection process include due diligence on the manager universe, quantitative analysis, and qualitative analysis. Assessing the manager universe involves evaluating the suitability of the investment policy statement with client objectives and constraints. The manager universe is also assessed based on style and the degree to which passive and active management are balanced. Quantitative analysis includes an evaluation of key performance metrics such as those used for attribution and appraisal analysis. Quantitative analysis also includes the use of the capture ratio (to measure return asymmetry) and drawdowns (the total peak-to-trough loss for a specified time period).

Qualitative analysis is a two-step process that involves both investment and operational due diligence. We will discuss operational due diligence in more detail later in this newsletter. Investment due diligence covers questions related to philosophy, process, people, and portfolio construction. Due diligence may involve asking the following questions: What market inefficiency does the manager seek to exploit? Is the investment process capable of exploiting this inefficiency? Do the investment personnel possess the expertise and experience necessary to effectively implement the investment process? Is portfolio construction consistent with the stated investment philosophy and process?

Manager Selection and Errors in Hiring/Retaining

Return-based and holdings-based analysis can be used to assess a manager’s style and assist in the selection process. Returns-based style analysis is a top-down approach that estimates the portfolio sensitivity to security market indices for a set of key risk factors (e.g. value, size, momentum). The returns-based approach is straightforward. It identifies the important drivers of return and risk and can be used for complicated strategies. It also has the benefit in that it is comparable across managers and through time. The disadvantage with returns-based style analysis is that it is an imprecise tool. The process involves attributing performance to an unchanging average portfolio which may not reflect current and future performance.

Holdings-based analysis on the other hand is a bottom-up process that reflects the actual securities in the portfolio. Holdings-based analysis allows for the estimation of current risk factors and should identify all important drivers of return and risk. Like returns-based analysis, it has the benefit of being comparable across managers and through time while providing an accurate view of the manager’s risk exposures. However, holdings-based analysis has several drawbacks. The calculation process is computationally intense, it is dependent on the degree of transparency provided by the manager, and there is a possibility that accuracy may be compromised by stale pricing and window dressing.

Regardless of whether returns-based or holdings-based analysis is used in the manager selection process, there is a risk that the client could make the wrong decision in hiring or retaining and investment manager. What are the potential errors a client could make? In considering this question, we use the term “skill” as an indication of whether the manager will meet the client’s investment objectives. The client may hire/retain a manager that they believe is skilled when in fact, the manger has no skill. This is referred to as a type 1 error or error of commission. A client may also fire/not retain a manager that they believe has no skill, when in fact the manager does have skill. This is a type 2 error or error of omission. Type 1 errors are generally more visible than type 2 errors since performance for a manager that is fired or not hired is a counterfactual scenario that is difficult to observe.

Investment Philosophy and Investment Decision-Making

When selecting an investment manager, the philosophy of the manager is an important consideration. In general, the manager will take a passive or active approach to investing. A passive approach is taken when the manager believes that markets are efficient. An active approach is used if the manager believes that there are behavioral inefficiencies or structural inefficiencies that can be exploited to generate alpha.

Investment personnel and the investment decision-making process are also important considerations in manager evaluation. The client should consider the following items related to investment personnel: expertise and experience; market depth to execute strategy; key person risk; employee retention; and employee turnover. The investment decision-making process is a multi-step sequence. The client will want to understand the decision-making process in order the gain insight on how their funds will be managed. Investment decision-making starts with idea generation. With idea generation, it is key that information used in the process is unique, timely, and interpreted differently in order to gain an investment edge. Next is idea implementation, followed by portfolio construction and portfolio monitoring. Effective operations are essential to the decision-making process. The client’s operational due diligence should ask the following questions about process, procedures, the firm, and the investment vehicles: Is the back office strong, does it safeguard assets, and is it able to issue accurate reports in a timely manner? Is the firm profitable, with a healthy culture, and likely to remain in business? Is the firm committed to delivering performance over gathering assets? Is the vehicle suitable for the portfolio needs?

Manager Account Types, Contracts, Fees

Account types that the client may consider are pooled investment vehicles and separate accounts. Pooled vehicles bring together funds from all investors into one portfolio. Separate accounts hold the funds of one investor in isolation. Separate accounts typically have higher cost, but the investor will have better control over their assets and will have the ability for customization. Separate accounts are also more tax efficient, permit separate reporting, and have greater transparency.

Investment manager contracts can be for closed-end funds and exchange-traded funds. These funds have high liquidity and trade intra-day. Open-end funds have high liquidity, but only trade at the end of day. Limited partnerships are common investment vehicles for hedge funds, private equity, and venture capital. Limited partnerships commonly have low liquidity due to capital calls and capital tie-ups. As a result, the investment may only get returns 5 years into 10-year fund. The prospectus, private placement memorandum, or limited partnership agreement is the contract between the investor and the manager. The contract outlines each party’s rights and responsibilities, liquidity provisions, terms, and fees. While limited liquidity reduces the investor’s flexibility, it allows the funds to take long-term views and hold securities with low liquidity. The fund also has a reduced risk of having to divest assets at inopportune times.

The assessment of manager fees is an important component of investment manager selection given that fees have the potential to significantly impact investor returns. There are three basic forms of performance-based fees. The first type is a symmetrical fee structure. Symmetrical fees have full up/down exposure with a base fee plus performance sharing component. The based fee is derived from assets under management while the performance sharing component is based on the excess returns over a given hurdle rate. The second type of performance-based fee is the bonus with full up/down exposure. With this fee structure, the fee is the greater of the base fee or the base fee plus a share of any positive performance. Finally, there is the bonus with limited up/down exposure. In this case, the fee is the greater of the of the base fee or the base fee plus a share of any positive performance up to a certain limit. A management fee lowers the level of realized return without affecting the standard deviation. A performance fee on the other hand will lower the realized standard deviation. For the client, a more-linear compensation will reduce the incentives to change the portfolio’s risk profile at inflection points.

Implications for ESG Investing

Having provided and overview of investment manager selection, we now turn our attention to the implications for ESG-investing. While asset owners may focus most of their time and attention on asset allocation and portfolio management, manager selection is an important consideration for the two-thirds of total assets under active management. Increasingly, asset owners are incorporating ESG and diversity issues into the manager selection process ^[2].

The United Nation’s Principles for Responsible Investment (PRI) have developed an asset manager selection guide so that asset owners can better use ESG insights to advance investment outcomes ^[3]. The guide outlines four areas for asset owners to consider in the investment manager selection process: investment approach; portfolio construction and investment decision-making; engagement and voting; and reporting. Assessing a manager’s investment approach is the first step in investment manager selection. Asset owners should seek to understand how the manager will produce value by leveraging ESG insights. This will require and understanding of the business and investment philosophy of the asset manager and should align with the asset owner’s investment objectives and constraints. An investment policy statement should outline the asset owner’s views on investment management including the incorporation of ESG-related factors. The culture, style, and size of an investment management firm will inform the investment governance approach. The governance and operational due diligence assessment will also extend to the quality and suitability of external vendors.

After considering an investment manager’s investment approach, the PRI document specifies some guidelines related to portfolio construction and investment decision-making. While the investment decision-maker is ultimately free to act independently, ESG insights must be presented and considered in the investment process. If the analysis fails to incorporate ESG considerations, the asset owners should correct this oversight with their investment managers. Failure to consider ESG and taking a narrow view of risk and return could ignore the significant contributions that an investment portfolio could be making to society at large. Parameters like tracking error can be important metrics given their direct influence over the choice of investments. Likewise, thematic and screening approaches are important for asset allocation and play an increasingly important role for advancing specific social or environmental causes, from gender and racial equity to protecting the rainforest. Asset owners that include impact investments in their portfolios should seek to understand how the investment managers define and measure such impact. Ultimately what gets measured gets managed – so this important step should not be overlooked.

The engagement and voting processes are important as these activities can directly impact financial performance of the portfolio under management. The reporting of portfolio performance from the manager to the asset owner should also be assessed to ensure transparency around investment-related information. Given these considerations, how can the asset owner assess the investment manager’s ESG integration practices? There are three general approaches that can be used. These include:

1. screen the market to shortlist managers that meet both ESG and investment needs;
2. ask the manager to disclose ESG integration capacities through a request from information or request for proposal; or
3. hold meetings with asset managers to further understand the manager’s investment approach, process, and ESG integration capabilities ^[4].

With this guidance in hand, asset owners will have the tools to ensure asset management is aligned with their investments and ESG objectives.

Conclusion

As we look to put you in the shoes of the asset manager, our hope is you will gain a deeper understanding of ESG integration and the investment management process. The companies that understand the asset manager’s decision-making rationale for incorporating sustainability and climate-related risk are likely to be the most responsive to changing investor requirements and trends. As global efforts are made to transition the economy to a more sustainable, lower-carbon future, we expect that investor demands for sustainability performance and disclosure are set for significant growth. Companies should begin to prepare today in order to meet investor expectations in the future. This will require having the right infrastructure for collecting sustainability-related data, understanding performance, reporting on key indicators, and setting targets to improve. Ultimately, companies that can master this core competency will gain more shareholder interest and will be poised for superior performance. Now is the time to seize the opportunity in the shift to sustainable investment.

References

1. https://www.msci.com/www/blog-posts/which-esg-issues-mattered-most/01934601065
2. https://blogs.cfainstitute.org/investor/2016/02/11/current-thinking-in-investment-manager-selection/
3. https://www.unpri.org/download?ac=4355
4. https://www.unpri.org/manager-selection/considering-esg-integration-in-manager-selection/26.article

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