As defined contribution participants increasingly demand more socially responsible investments, plan sponsors need to consider their ESG options.
Environmental, social and governance (ESG) investing has become increasingly important, as the percentage of U.S. institutional investors who use ESG factors in investment decisions rose to 29% in 2015 from 22% just two years earlier, according to Callan. Nearly half use ESG to mitigate risk while about a quarter uses it to seek improved performance. More importantly, nine of 10 managers who incorporated ESG into their investments did so because their clients asked them.
So, it’s no surprise we are seeing interest from defined contribution (DC) plan sponsors to mitigate risk, seek opportunities and offer more options to their participants investing for retirement. ESG analytics can be integrated into portfolio construction and combined with fundamental analysis or quantitative signals. Here are four questions to ask when considering ESG strategies for your investment menu.
- Are there strong organizational values that should be reflected in investments?
Identify whether your organization has strong values that should be captured in ESG strategies. This often pertains to organizations with values that may not align with certain industries. For example, religious institutions may screen out gambling stocks, healthcare companies may exclude tobacco stocks, and public funds may screen on climate change. Women and millennials, in particular, are creating demand for investments that align with corporate values. One of every three members of the workforce is a millennial, outnumbering any other generation.
- Are ESG ratings being used to mitigate risk and gain opportunities?
ESG analytics and ratings have historically improved over the years. ESG ratings can now be used as a risk mitigation technique or an opportunity seeking technique. The highest-rated companies are evaluated versus competitors and should have lower risk and less potential for controversy. Ratings can flag companies that would worry a typical ESG investor, such as corruption at the board level. Ratings can help target companies to underweight in or eliminate from a portfolio.
For example, Volkswagen was flagged as having poor governance before its emissions scandal. Based on analysis available before the scandal, investors could deduce that the company was not viable long-term until corruption and discrepancies at the board level were fixed.
Alternatively, overweighting the best firms potentially creates more opportunities. There is a misperception that investing in ESG means giving up performance. In fact, studies have shown that ESG strategies have historically performed in-line or better than strategies that reflect the broad market. We have to ask ourselves: when we are offering employees a defined contribution and investment plan, should we not be considering the highest quality companies anyway?
- Are investors getting a voice with shareholder engagement?
Proxy voting gives shareholders a say in values that are important to them. Plan sponsors should consider the extent of engagement they want for potential strategies. Approaches can vary from strategies with “straight-off-the-shelf” proxy policies that use recommendations from proxy services or funds that customize voting based on guidelines from clients. The most progressive strategies typically vote in favor of corporate transparency, policies to fight climate change and improved corporate governance.
- Should strategies be active or passive?
Active strategies allow investors to take a “best ideas” stock picking approach to investing, which can lead to potentially rewarding performance and likely more volatility. For investors looking for thematic investments with a potential outperformance target, active strategies could be appropriate. Passive investments give investors broad and efficient market exposure. Typically, the passive route is the best way for clients to gain exposure and diversification with timed rebalancing and clear investment rules. For those DC plans that have an ESG policy or would like to marry their values with their investments, passive vehicles may remove uncertainty over how investments are chosen.
Sabrina Bailey is Global Head of Retirement Solutions, and Mamadou- Abou Sarr is Global Head of ESG with Chicago-based Northern Trust Asset Management.