Thinking ahead

Advisors know it’s important to shield assets from future risks. For certain foundations, pensions and high-net-worth people, these risks include environmental, social and governance (ESG) issues.

Foundations see ESG issues as important to the credibility of their organization. It’s vital they invest in accordance with their mission and core values; otherwise, they risk breaching their fiduciary duty.

Pensions increasingly view themselves as universal owners that depend on a stable and growing economy. Environmental degradation and social unrest are impediments to long-term economic growth, so pension groups like CPPIB, BCIMC, and Québec’s CDP have created ESG policies and are taking steps to address these issues.

ESG issues can also be used to generate alpha by exploiting market inefficiencies. For example, companies with better ESG disclosure have a cost of capital that is up to 64 basis points less than their non-ESG-disclosing peers.

Meanwhile, firms that have a higher percentage of women on their boards of directors outperform their all-male counterparts to the tune of 4.8% annual return on equity.

Markets haven’t yet figured out how to price certain ESG issues, and savvy investors can beat the street by paying attention. Since the majority of portfolio managers haven’t integrated ESG into their risk analysis, asset owners are starting to search for managers who use ESG risk assessment to achieve superior risk-adjusted returns.

Here’s how the search process works.

• Everyone has their own idea of what ESG means, so an investment consultant first asks the client open-ended questions such as “What non-profit organizations do you support?” and “What does your ideal world look like 20 years from now?”

  These questions are designed to help the consultant understand the client’s reasons for wanting to integrate ESG analysis, and help identify specific risks the manager ought to be considering.

• The second phase of a manager search involves creating a short list of managers by assessing each offering based on ESG analysis combined with traditional financial analysis.

  The first to go are managers who simply purchase third-party ESG research instead of integrating research into their methodologies.

  Next, managers consistently underperforming their benchmark are ruled out. The remaining managers are ranked based on their knowledge of ESG issues core to the client’s mission.

• The final stage places shortlisted managers in front of the client. Often, some companies in the portfolio aren’t up to a client’s ethical standards. Canadian funds can’t eliminate entire sectors like energy, materials and finance without seriously compromising the integrity of the portfolio.

  The best managers understand how ESG issues are affecting macro trends — like energy prices and the rise of the global middle-class — and can identify which companies are best positioned to outperform by creating efficiencies and gaining market share.

Managers who use this integrated ESG approach are more effectively considering emerging risks like water scarcity, carbon pricing, and human-rights violations in the supply chain.

At the same time, they are capitalizing on opportunities to invest in companies that are creating solutions for tomorrow’s problems.

Currently, $463.4 billion of Canadian assets consider ESG issues, with the vast majority coming from pension funds that have signed the United Nations Principles for Responsible Investing. However, signatories have only made a commitment, and many are struggling with implementation.

Furthermore, retail investors are looking for ESG solutions, but few advisors have the ability to help. Advisors would do well to educate themselves on these issues, as it will help differentiate their firm and open the door to a growing number of large accounts.

Timothy Nash is president of Strategic Sustainable Investments, a Toronto-based consulting firm that specializes in ESG manager searches and green impact investments.