Chap 9 Flashcards
CHAPTER 9
INVESTMENT MANDATES, PORTFOLIO ANALYTICS AND CLIENT REPORTING
The veteran founder of Vanguard, John Bogle, called our society a “double-agency” one – namely, a society in which corporate agents (as a practical matter, corporate CEOs) “who are duty-bound to represent their shareholders face money manager/agents who are themselves duty-bound to represent their mutual fund shareholders and their other clients, often pension funds.”
According to Bogle, there is a similarity between the agency problem that corporate governance is designed to address and the agency problems that occur within the investment chain. As with corporate governance, these investment chain agency problems can be addressed (though not completely solved)…
…by careful alignment and accountability:
▶ alignment should be designed so that the timeframes and structures of portfolio manager assessment and remuneration closely reflect the performance experienced by the clients and the timeframes over which they need performance to be delivered; and
▶ accountability should mean that portfolio managers respond to the clearly expressed intentions of the clients and report as fully as required.
Client mandates can deliver these two elements, if they are designed well.
A. Clarifying client needs and objectives
The first step in the effective design of a mandate is that the client should be clear about their needs and should be able to describe these in the requests for proposal (RFP) that they issue for a mandate. Doing so will require them to define their investment goals and beliefs.
Institutional clients will typically be keenly aware of the goals that they are trying to achieve (their risk-adjusted return target over the appropriate time horizon), but may find it harder to define their investment beliefs.
Nevertheless, it is these beliefs that will help them to define how they believe they will create value and to set their investment approach. The investment beliefs – that might be expressed in a
Statement of Investment Principles
– ought to guide the overall approach towards ESG and will help to frame any mandate agreed with an investment manager.
B. Aligning investment with clients’ beliefs
As suggested by a PRI report, asset owners should ensure that mandates align investment across asset classes with their beliefs and strategies:
“Attention should be paid to aligning timeframes through fees and pay structures, ensuring that ESG issues are fully integrated into investment decision-making, and ensuring that the investment manager engages with companies and issuers, and votes shareholdings.
C. Proposing ESG-aware investment mandates
The ICGN Model Mandate Initiative: Model contract terms between asset owners and managers provides a helpful framework and proposes best practices for ESG-aware investment mandates around:
▶ the monitoring and use of ESG factors;
▶ the integration of ESG factors into investment decision-making;
▶ adherence to good practice around stewardship; and
▶ voting and reporting requirements.
As the document states:
“As important as setting standards within fund management contracts is how clients can effectively call their fund managers to account in respect of these mandates.
The intended standards will most effectively be delivered where managers are made accountable on a regular basis for their delivery against them.”
According to the 2016 PRI report, referred to above, investment mandates should require investment managers to:
▶ Implement the asset owner’s investment beliefs and relevant investment policies.
▶ Integrate ESG issues into their:
» investment research;
» analysis; and
» decision-making processes.
▶ Invest in a manner consistent with the asset owner’s **time horizons, understanding the key risks that must be managed to achieve the asset owner’s portfolio goals.
▶ Implement effective stewardship processes, including:
» engagement with companies and issuers on ESG issues; and
» for listed equities, voting all shareholdings.
This engagement should align with the asset owner’s responsible investment and related policies.
▶ Engage constructively and proactively with policymakers on responsible investment and ESG-related issues. This engagement should align with the asset owner’s responsible investment and related policies.
▶ Report on the actions taken and outcomes achieved. The reporting should enable the asset owner to:
» assess the manner in which the investment manager has implemented the asset owner’s investment beliefs
and policies; and
» understand how this has affected investment performance and ESG outcomes and impacts.
D. Linking sustainable investing to the mandate
On occasions, the specific ESG (or other) requirements of a client are not included in the contractual mandate itself, but in a side letter, which also has contractual status.
An insight into this model is provided by the
*****Brunel Asset Management Accord.
This document sets out a pension manager’s approach to long-term investment and ESG factors,
but in a form of words that it believes is less-suited to the hard legal language of a specific contract, but more to a softer form of agreement whereby the fund managers are enabled more clearly to understand the client’s perspective and so, align to it.
For the purposes of this chapter, we talk about mandates in a way that encompasses side letters or any other legal documents that frame the agreement between a client and a fund manager.
The issue of time-horizons of the asset owner, and the overall investment philosophy, incorporating the institution’s understanding of ESG factors and their impact on value over those time-horizons, goes to the core of delivering mandates that actually encourage fund managers to respond appropriately to ESG risks and opportunities.
As the ICGN’s Model Mandate puts it:
“The time horizon of most asset owners is considerably longer than that of fund managers. Thus for long-term portfolios, the factors and risks which matter to the asset owner are somewhat different from those typically considered within fund management processes. But as these factors and risks will impact their long-term returns, many asset owners are keen to see more effective integration of these longer-term factors into investment processes.”
E. Defining the sustainable investment strategy
In order to incorporate the longer-term perspective discussed in sub-section D above and an ESG mindset into the mandates that the asset owners give fund managers, asset owners need themselves to have developed
a clear understanding of their views on ESG and investment more generally.
It has become common now for asset owners to set out their investment beliefs – namely, a philosophy of what the institution believes will drive returns and deliver value over the relevant time-horizon.
Most asset owners these days incorporate a perspective on ESG factors.
The Pensions and Lifetime Savings Association (PLSA) produces a **Stewardship Checklist for its members, which encourages just such a development of a broader philosophical approach.
In this checklist (useful not just to pension schemes but for all asset owners) there are three key bullet points.
PLSA Stewardship Checklist
As the PLSA indicates, the investment philosophy is often shaped by the overall purpose of the organisation, set by its founding documents.
For many asset owners now, it is vital that ESG is integrated within that purpose.
Not least because, since October 2019 changes to the ***UK’s Occupational Pension Scheme Investment Regulations (2005) have required pension schemes to set out in their Statement of Investment Principles
(SIP) their policies on how they consider financially material ESG factors within their investment approach,
as well as the extent to which they undertake stewardship, including engagement and voting. New reporting requirements, in line with Europe’s Shareholder Rights Directive II, will reinforce this. The starting point for the investment process often starts with how ESG is viewed in the context of an investment philosophy or purpose.
Two reasonably representative examples of how such purposes are articulated by major global asset owners are shown below:
As the PLSA indicates, the investment philosophy is often shaped by the overall purpose of the organisation, set by its founding documents.
For many asset owners now, it is vital that ESG is integrated within that purpose.
Not least because, since October 2019 changes to the *UK’s Occupational Pension Scheme Investment Regulations (2005)
have required pension schemes to set out in their Statement of Investment Principles
(SIP) their policies on how they consider financially material ESG factors within their investment approach,
as well as the extent to which they undertake stewardship, including engagement and voting.
New reporting requirements, in line with Europe’s Shareholder Rights Directive II, will reinforce this.
The starting point for the investment process often starts with how ESG is viewed in the context of an investment philosophy or purpose.
Two reasonably representative examples of how such purposes are articulated by major global asset owners are shown below:
From CPP Investment Board (Canada):
“CPP Investments invests the assets of the CPP with a singular objective – to maximise returns without undue risk of loss taking into account the factors that may affect the funding of the CPP.
Our investment strategy is designed to capitalize on our comparative advantages while ensuring we maintain our commitment to responsible investing”.
From AustralianSuper:
“We work hard to maximise investment returns over the long term, so members can enjoy a better future. As long-term investors, we focus on investing in a mix of quality assets that can grow members’ savings over time.
We balance this with an understanding of the risks we need to take to achieve this objective and deliver competitive returns against our peers.
Our four core investment beliefs are the foundation of our investment approach.
A rigorous governance framework and disciplined investment process help us allocate and manage members’ savings and maintain our position as one of Australia’s leading super funds.
Our four investment beliefs:
- We return all profits to members.
- We believe in active management – both asset allocation and stock selection.
- We use our scale to reduce costs and better structure investments.
- We’re aware of our responsibility to the broader community, consistent with our obligations to maximise benefits to members.”
How the purpose and investment beliefs and philosophy see ESG impacting investment performance – whether as risk factors or value creators – will shape how ESG is integrated into mandates and what the asset owner
will expect of its fund managers.
This is well-articulated in a McKinsey article from October 2017.
The article provides a framework for considering how to develop a policy and philosophy, and then how it can practically be implemented.
It states that:’
“A sustainable investment strategy consists of building blocks familiar to institutional investors: a balance between risk and return and a thesis about which factors strongly influence corporate financial performance.”
Responding to these two building blocks, McKinsey suggests that there are two fundamental questions that asset owners need to ask in developing their ESG investment philosophy:
- Are ESG factors more important for risk management or value creation?
“If the mandate focuses on risk management, then the strategy might be designed to exclude companies, sectors, or geographies that investors see as particularly risky with respect to ESG factors, or to engage in dialogue with corporate managers about how
to mitigate ESG risks. If value creation is the focus, on the other hand, investors might overweight their portfolios with companies or sectors that exhibit strong performance on ESG-related factors they believe are linked to value creation.”
- What ESG factors are material? McKinsey notes that this is much less straightforward than the simple statement of the issue might make it seem, and that there are substantial reporting projects dedicated to identifying what is material at a sector level, let alone an individual company level. The nature of the investment portfolio also adds a layer of complexity, the firm argues:
“The selection of material factors is often influenced to some extent by exposure to asset classes, geographies, and specific companies.
For example, ***governance factors tend to be especially important for private equity investments, since these investments are typically characterised by large ownership shares and limited regulatory oversight.”
EMBEDDING ESG INVESTMENT
Explain how ESG screens can be embedded within investment mandates/portfolio guidelines to: generate investment returns; and manage portfolio risk.
Once the asset owner client has developed its investment philosophy and beliefs, this then needs to be translated into the specifics of the mandates that it awards to its fund managers.
As McKinsey indicates, there are two key elements of this:
- Is ESG a risk management tool or a source of investment advantage?
- Which aspects of ESG most matter from the perspective of the asset owner?
Determining the answers to these questions will be the starting points for shaping the mandates awarded.
Furthermore, in shaping the detailed expectations, the answers will need to be reflected in the terms of the individual mandates themselves.
Example
Pension fund concerned about climate change
A pension fund has strong beliefs regarding the impending impacts of climate change.
▶ The fund might establish multiple mandates investing in new technologies, including renewable energy generation.
▶ The fund’s mainstream equity and debt mandates may well include screens that exclude fossil fuel investments.
▶ The fund may require that any sovereign bond mandate includes an active ESG overlay that seeks to limit exposure in countries where the physical impacts of climate change are likely to be most acute.
Example
Foundation investment portfolio concerned about human rights abuses
A foundation investment portfolio, where the investment beliefs feature major concerns regarding human rights abuses, might be more likely to:
▶ apply a screening approach across portfolios requiring the exclusion of any investment facing significant allegations; and
▶ ***screen out exposures to certain countries where human rights abuses are perceived to be a frequent occurrence or where human rights standards are deteriorating at a rapid rate.
______
Naturally in practice, the investment beliefs and so the mandates that are created to reflect them, are rarely as one-dimensional as the two examples above might imply.
Furthermore, the client will always have an expectation of investment returns being generated alongside delivery of whatever broader expectations it places on the investment approach.
The McKinsey article also provides a helpful framework for understanding the different ways in which ESG considerations can be reflected in an asset owner’s investment approach and so, be fully operationalised in the work of its fund managers.
DIMENSION OF INVESTING
ELEMENTS OF SUSTAINABLE INVESTING
Investment mandate
• Consideration of ESG factors, including prioritisation.
• Targets
Investment beliefs and strategy
• Rationale for ESG integration.
• Material ESG factors.
Investment operations enablers: ✓ Tools and processes • Negative screening. • Positive screening. • Pro-active engagement.
✓ Resources and organisation
• ESG expertise and capabilities.
• Integration with investment teams.
• Collaborations and partnerships.
✓ Performance management
• Review of external managers (screening and follow-up). • Follow-up on internal managers (including incentives).
✓ Public reporting
• Accountability.
• Transparency.
Fund managers themselves, hoping to win mandates that reflect ESG concerns, will seek to develop their
own policies that fully integrate ESG approaches into their portfolio management.
This is both an element of marketing their approach and differentiating themselves in a crowded investment marketplace.
An overarching policy also helps to train and shape the mindset of the investment teams themselves.
An ESG policy should formally outline the investment approach and degree of ESG integration within a firm
Such an ESG policy is an opportunity for a fund manager to highlight the relevance, or in some cases the lack of relevance, of responsible investment norms and principles (like those issued by the PRI) to a firm’s investment strategy or strategies.
A number of investment strategies face inherent challenges, some of which may be due to:
▶ the lack of ESG data within their scope; or
▶ a relative scarcity of methodologies and best practices to apply ESG integration within an asset class.
Here are two examples of ESG philosophies from leading fund management firms.
RBC Global Asset Management:
“We invest in sustainable great companies at attractive valuations and steward them for the long term.
We use intangible, ESG and business assessment combined with strong risk analysis to achieve this.
Financial analysis and ESG assessment are intertwined
in judging a business.
Businesses thrive over the long term when they invest in ESG intangible factors that lead to stronger more sustainable financials.
We consider ESG factors as non-traditional sources of risk and opportunity which we believe should form part of every company assessment…
The relevance of particular ESG issues varies from industry to industry, which is why we believe it is important to integrate ESG into the company assessment … rather than as a pre-screen or overlay.
It facilitates engagement and ensures ESG risks and opportunities are incorporated into the fundamental valuation analysis driving financials.”
Generation Investment Management:
“Our investment process underpins our differentiated thinking about the dynamics that drive and influence the performance of companies.
We construct portfolios of sustainable companies with the confidence derived from our deep research and analysis.
A sustainable company is:
(1) one whose current earnings do not borrow from its future earnings;
(2) one whose sustainability practices, products and services drive revenues, profitability and competitive positioning; and
(3) one that provides goods and services consistent with a low-carbon, prosperous, equitable, healthy and safe society.”
These philosophical statements then need to be operationalised into ESG policies that cover a range of practical issues.
Regardless of the investment strategy or asset class, such an ESG policy needs to address the manner in which the portfolio manager:
▶ addresses ESG issues at portfolio reviews;
▶ establishes the rationale and methodology for ESG portfolio-level assessment;
▶ assesses exposure to ESG risk within the risk management function;
▶ determines ESG impacts to the portfolio;
▶ responds in the investment decision-making process to ESG implications; and
▶ discloses ESG exposure to the fund’s investors.
