The ESG Takeover

Is environmental, social, and governance investing actually serious business for Europe’s largest investors?

How do you make money from having a conscience? 

The 20th century version of capitalism says you don’t. Screening out tobacco, alcohol, munitions, or other controversial investments is a sure-fire way to remove diversification from a portfolio, and can remove some of the best performers in the stock market. Environmental, social, and governance (ESG) concerns are too intangible to measure and are no more likely to match your liabilities than any other investment.

Except… that argument doesn’t really stand up any more.

A global survey of asset owners by Switzerland-based LGT Capital Partners, published last month, reports that more than half of the 97 investors questioned feel ESG criteria have a direct positive effect on risk-adjusted returns. Only 9% feel they are a drag on performance.

And ESG orientations are no longer applicable only to mainstream equity and fixed-income funds. Asset owners across Europe are putting pressure on managers of private equity, infrastructure, and hedge funds to incorporate sustainability into the core of their investment processes. And if they resist, managers are finding important doors are closed to them.

Welcome to the 21st century—and a new approach to investing.

CIO-Europe-April-2015-Feature-Marcos-Chin-storyArt by Marcos Chin

In a 2012 paper titled “Sustainable Investing: Establishing Long-Term Value and Performance,” Deutsche Bank’s Mark Fulton details the evolution of ESG investing.

There are essentially three categories of sustainable investment, the German bank’s global head of climate change investment research states. Their acronyms—SRI (socially responsible investing), CSR (corporate social responsibility), and ESG—are well known, but often tend to merge into each other, making unclear the nature and requirements of adopting such an approach.

Dan Ingram, head of responsible investment at the BT Pension Scheme, agrees.

“Those that work in responsible investment have been talking in a slightly different language to the mainstream sometimes,” he says. “If we haven’t even begun to define our terms, that’s a bit of a problem. It hasn’t helped some of the conversations we’re having with the fund managers.”

“The increasing mainstream interest in ESG is now motivated by an interest in integration, bringing it into processes to add value.” —Thomas KuhBut the definitions are slowly becoming clearer. In his paper, Fulton—along with former colleague Camilla Sharples and Columbia University’s Bruce Kahn—defines SRI as primarily the use of “exclusionary screens”. SRI funds have “historically struggled to capture” the returns on offer from sustainable investing, the trio argue in their paper. Of the studies the authors examined, 88% showed “neutral or mixed results” for SRI funds. This is the old way.

In contrast, modern ESG funds are capturing returns far better using a positive “best-in-class” approach, as fund managers integrate criteria further up their investment processes.

“Mostly, the approach a generation ago was screening,” says Thomas Kuh, head of ESG indices at MSCI. “That’s still an important component, but the increasing mainstream interest in ESG is now motivated by an interest in integration, bringing it into processes to add value.”

The question is: How do asset owners know they are adding value?

In terms of performance and returns, measuring is fairly straightforward. There are dozens of ESG-friendly versions of major global and regional indices available from multiple providers to pit mandates and funds against, and new ones launch regularly. MSCI rolled out a series of low carbon indices in September 2014, followed in October by benchmarks excluding fossil fuel companies.

“The academic and practitioner literature is pretty clear that there is no evidence to expect systemic underperformance,” Kuh adds, “and there are reasons to believe that you might get some performance benefits.”

The literature is backed up by the reality, as an ESG tilt seems to have benefitted MSCI’s regular indices, at least marginally. The MSCI All Countries Europe ESG index gained 27.6% in dollar terms from its launch in September 2013 to April 2, 2015, according to data provider FE Analytics. The non-ESG version gained 25.7% in the same period. The ESG version of the MSCI All Countries World index outperformed its non-ESG sibling by 95 basis points in the same timeframe.

It’s not all about performance, however. As MSCI’s Kuh explains, ESG criteria are being integrated “not necessarily to improve performance, but to identify risks as well.”

Tycho Sneyers, managing partner at LGT Capital, agrees that asset owners see a responsible, sustainable approach as “a valuable risk management tool.” However, “how to measure this is not so easy,” as normal performance and risk measurements are not necessarily applicable. “Long-term returns are more driven by avoiding bad investments than by having all the winners,” he says. By using ESG criteria this way, he argues that investors can screen out some of the less tangible or predictable risks, such as those related to climate change or human rights—risks that can’t necessarily be measured on a neat numerical scale.

Another way of measuring value is through the impact specific actions have had on those directly affected by them. These are primarily the aspects of ESG that do not affect a pension fund’s portfolio directly.

“Climate change is more
and more recognised as a financial risk and it is our duty, as trustees, to take concrete steps to reduce this risk.” —Mats Andersson
As one sustainability manager at a major UK pension explains, the effectiveness of an investor’s governance strategy can be measured by new jobs created or by a positive change in a company’s efficiency. “If you believe it will create value then you should do it,” the manager adds. “We don’t have the answers to all questions but that doesn’t mean we shouldn’t do it.”

Sweden’s public sector funds have taken this to heart and led Europe in active sustainable investing. AP4 CEO Mats Andersson is particularly vocal on such issues, and in September the United Nations tasked him with leading the international Portfolio Decarbonization Coalition (PDC).

“Climate change is more and more recognised as a financial risk and it is our duty, as trustees, to take concrete steps to reduce this risk,” Andersson says. By the end of this year the PDC aims to have $100 billion (€91 billion) in assets signed on to its cause, with a longer-term aim of $500 billion (€455 billion). Investors joining the PDC promise to disclose the carbon footprints of their portfolios and, subsequently, reduce them. Andersson calls the $100 billion target “a significant amount but it is absolutely feasible”.

“We hope that by reaching this target, investors can show that a different course of action is possible, where institutional investors’ goals are aligned with and support the common good,” he adds.


Bristol, the biggest city in southwest England, has changed drastically in the past 100 years. At the beginning of the 20th century its economy relied on heavy industry and the city’s port. Now Bristol has a blossoming cultural scene and is home to a growing number of financial services companies. It is also one of the greenest places in the UK, having been crowned the country’s most sustainable city in 2008 by Forum for the Future.

Bristol is the perfect home, then, for one of Europe’s most forward-thinking responsible asset owners. Mark Mansley is the soft-spoken CIO of the Environment Agency Pension Fund, overseeing a £2.3 billion (€3.2 billion) portfolio.

Since joining the pension in 2011, Mansley has led an aggressive push to bring the entire portfolio under a responsible investment framework. Private equity is where the pension has been most successful. The sector “has realised that there’s an advantage of getting its act together,” Mansley says, and there are more “responsible private equity houses” than 10 years ago when the pension first adopted its orientation.

“The industry is much more engaged: managers see there is a story there and a need to be able to demonstrate their engagement,” he adds.

LGT Capital’s research reports that more private equity and hedge fund managers are incorporating ESG concerns into their investment processes—due primarily to investor pressure.

“Private equity managers have taken ESG to heart and are making good progress,” says LGT’s Sneyers. Asset owners are leading the push: 33% told the surveyor that a private equity manager’s ESG approach was a “significant” factor in the selection process.

In Sweden, AP6 can testify to the truth of this. The smallest of the country’s public pension funds at SEK 23.6 billion (€2.5 billion), it focusses purely on private equity investments—but with sustainability and responsible investing at the heart of its process. Of particular importance are anti-corruption, human rights, labour law, and environmental issues.

In its 2014 sustainability report, AP6 admitted to encountering difficulties when assessing the climate impact of its investment portfolio. The review covered only 80% of its holdings by value, as “it is relatively uncommon for unlisted companies to publicly report carbon dioxide emissions.” However, the fund still reports that its assets are “less carbon dioxide-intensive” in aggregate than its comparison MSCI World index.

Back in Bristol, the Environment Agency pension’s real estate holdings have gone on a similar journey, helped by the introduction of the Global Real Estate Sustainability Benchmark (GRESB). The group was established in the Netherlands in 2009 and is backed by Dutch pension investors APG and PGGM.

PGGM’s internal real estate team has its own bespoke guidelines for incorporating ESG criteria into investment processes (as is likewise the case for infrastructure, private equity, and emerging market debt).

“We systematically include ESG information in our investment decision-making framework and weigh these factors together with other financial and non-financial factors in constructing the investment portfolio,” PGGM’s real estate guidelines state. “ESG factors are translated into our expectations with regard to rents and valuations. In this way, ESG factors impact our price targets, which in turn affect the composition of our portfolio.”


Despite the undoubted success of incorporating responsible investment criteria into multiple asset classes outside of listed markets, plenty of work remains unfinished.

Infrastructure funds are improving, according to LGT’s survey, and could get even their own standards board similar to GRESB. The Sustainability Accounting Standards Board is set to begin improving reporting standards at listed infrastructure companies this year.

Hedge funds are the standout laggards. Some pensions—the Environment Agency’s among them—do not invest in hedge funds at all because of their lack of compliance with ESG criteria.

Additionally, PFZW—the Netherlands’ pension provider for health care workers—cited sustainability concerns among its reasons for withdrawing roughly €4 billion from hedge funds last year. “PFZW concluded that hedge funds are no longer a good fit for the portfolio,” the €156 billion pension said in January, “given the high remuneration in the hedge fund sector and the often limited concern for society and the environment.”

However, for the BT Pension Scheme’s Ingram, a fund’s lack of a responsible investment slant is not an automatic deal breaker. “You don’t have to comply,” Ingram says. “We try to encourage really interesting explanations. As a fund manager you’ve then got to really scratch your head in that case and ask yourself, ‘Why doesn’t this apply to my investment strategy? Why isn’t this material to the stocks I hold?’ I think portfolio managers are good at that type of deep thinking.”

Ingram cites shorter-term, opportunistic equity funds or macro hedge funds as examples of strategies that could be less suited to adopting responsible investment tactics such as exercising shareholder voting rights.

“The next challenge would be integrating ESG into smart beta.” —Mark MansleyThis is reflected in LGT Capital’s survey: just 7% of asset owners said ESG factors were “significant” when selecting hedge funds. Of 74 hedge funds assessed by the Swiss firm in 2015, only three achieved its top rating for ESG reporting and compliance—although this was three more than in 2013.

“There are number of strategies in which you can quite easily argue that the price signals that ESG factors send are less relevant in the timeframe the manager’s looking at,” Ingram says. “If a manager is able to talk us through why they don’t think it is material, we’re comfortable with that. Up to a point.”

However, as LGT’s Werner von Baum points out, “certain styles are easily adaptable.” He points to long-short equity in particular: two of LGT’s three top-rated hedge funds are in this category. “Larger managers who seek money from large institutional investors around the globe are more likely to take on these [ESG] rules, and can afford it,” he adds. “Those that are just starting out may not be against it, but will find it more difficult.”

“The next challenge would be integrating ESG into smart beta,” suggests Mansley. The Environment Agency fund already has three smart beta mandates: value, low volatility, and a UK equity allocation with a 2% cap for individual holdings—essentially equal-weighted, without pushing up holdings in companies in the tail end of the index.

This idea has taken root elsewhere too. Index provider STOXX claims to have launched the first index combining an ESG screen and a smart beta tilt in 2011, with its STOXX Global ESG Leaders benchmark. AXA Investment Managers began trialling an ESG smart beta product in Australia last September, while S&P Dow Jones Indices announced the launch of the DJSI Ethical Europe Low Volatility index in March this year.

ESG investing is no longer an option, many would argue. It is the future of investing, they would say—and that future is very, very close.