When it comes to mandates like ESG, it's all about control

Imagine you’re responsible for the investments of a huge portfolio—one that is under intense public scrutiny. Perhaps the portfolio is an endowment belonging to Harvard or Yale or one of the many other universities facing student protests about your investment holdings. Or perhaps it’s the pension plan of a big consumer brand—and the current pressures of socially responsible investing are putting your portfolio in the brand bullseye. Or maybe the holdings of your teacher’s pension plan or sovereign wealth fund have suddenly become hotbed political issues.

How do you manage such a portfolio, in light of today’s public pressures? And the temperature of hot issues changes constantly, so what about tomorrow’s areas of scrutiny? You’ve spent your institutional-investing career focused on intense performance goals. But now you’re supposed to balance Environmental, Social and Governance (ESG) and other mandates as well, and still keep performance and risk controls intact? How? And how do you do all this without increasing the cost of ownership?

First and foremost, you’d better know what you own.

Know what you own and know why you own it.

Investors have long been comfortable with risk—market risk, liquidity risk, interest rates, inflation, etc.  Over the decades, an incredible amount of work has gone into managing these risks with the goal of maximizing the return provided for the risk taken. Legendary investor Peter Lynch is famous for saying, “Know what you own, and know why you own it.” As Lynch so keenly understands, managing portfolio risk starts with understanding what your portfolio contains.

One of the greatest tools devised to deal with the various risks inherent in portfolio management has been diversification, wherein an investor spreads their risks across different asset types, regions, sectors, countries, investing instruments, etc. The ironic outcome of maximum diversification, which is intended to reduce risk, is that it creates the risk of portfolio blindness—the risk that the portfolio gets complicated to the point where practical knowledge of your holdings, or portfolio control, gets diluted.  Maintaining a simple structure is a critical component to retaining portfolio control, but this simplicity is becoming increasingly elusive. Much of the modern approach to building diversified portfolios—and the investing infrastructure that has become the norm over time—can create additional complexity, rather than driving simplicity. We believe complexity reduces control. Simplicity increases control.

Reducing friction

In our experience, the desire for control has been a near constant. At Russell Investments, we’ve worked with a variety of institutional investors, from smaller retirement plan sponsors to the largest sovereign wealth funds in the world. Across our entire universe of clients, the consistent desire is for greater control of the assets they hold and the market risks they are exposed to. That desire for control makes sense. Markets seem to move faster than ever before and meaningful returns seem more elusive. Avoiding down-market events and seizing up-market opportunities requires nuanced responsiveness.

Unfortunately, all too often, the normal investing infrastructure—of multiple accounts across numerous, disparate managers—not only makes control less available, but it also increases friction. This friction is comprised of excess turnover across all managers, unknown or unmanaged factor exposures and a lack of access to underlying data in a reasonable amount of time to allow for timely decision making.  And this kind of friction can often lead to worse outcomes. Here’s a simple example: When employing a number of different investment managers within a portfolio, manager A may be selling the exact security that manager B may be buying in a similar timeframe. There are very few, if any, mechanisms that would make these managers aware of such crossing opportunities. Nor should the investor expect this of the manager.

The unacceptable normal

Within some multi-asset investment offerings, we have often seen this and many other inefficiencies arise through the normal investing infrastructure, wherein each underlying investment manager independently invests their portfolio within their own account, and the end investor is left to aggregate and try to adjust.  But we believe this slippage is unacceptable, especially when we have found it can be avoidable.

Investors should be able to demand more simplicity and less friction from asset management firms. We believe the best asset managers should have the ability to reduce friction by reducing unnecessary turnover. The best firms should be able to help control costs by centralizing the management of many investment manager portfolios within a single account. We believe the result of such an approach, beyond potential cost savings, is control. That control is possible because of simplicity—because of the resulting simpler investment process and the increased knowledge of what the portfolio contains.  Through aggregated, real-time access to underlying portfolio holdings data,  clients and portfolio managers should be able to exert control at the total-portfolio level, allowing them to manage the spectrum of portfolio risks in a vastly reduced timeframe.  Clients should be able to know what they own, allowing them to focus on why they own it.

The rise of constituent risk

We believe this level of control will continue to grow in importance.  Across the industry, we see new unexpected risks emerging that center on the ability of institutional investors to control and modify their investment holdings to meet the value-based needs of their constituents. We call this constituent risk. Applying to Environmental, Social and Governance (ESG) factors at a total-portfolio level is becoming a key criterion for many investment decisions. However, a precise ESG mandate can be difficult to apply consistently across multiple asset managers in today’s normal infrastructure. In many cases, the application of the mandate must be outsourced to the underlying managers to attempt to execute, often at a considerable increase in cost.

More often than ever, we see constituent risk increasing, where groups or individuals affiliated with investment pools seek to influence the ESG philosophy of the investment pool. More and more, we are seeing situations similar to Harvard and Yale, where the student population is encouraging the endowment to divest from fossil fuels and the prison industry. These divestment screenings and avoidance strategies have garnered considerable headlines and their frequency seems to be accelerating.

One approach investors have taken is to use passive investing vehicles for large portions of their portfolios, thus achieving a level of simplicity. They can then apply ESG filters at the index level. The downside here is that the investor is beholden to the index fund manager and potentially to their black-box ESG approach. Oftentimes, this can feel like a very blunt approach to a nuanced set of decisions.

The need for nuance

Tomorrow’s ESG demands can change from today’s. The ESG conversation changes constantly and there is no one single ESG mandate that all investors align to. We see different investors desiring the ability to apply their own bespoke philosophies to their portfolios, and rightly so, as the level of nuanced understanding of the impact of mandates continues to evolve as well. Take fossil fuels as an example of this evolution: Green-oriented constituents may demand a simple divestment approach¹, as seen in many of the student protests. But not all fossil fuel energy companies are the same. Ironically, some of the same companies that are seemingly the greatest abusers can be the same firms investing the most in green energy. Those investments may be vital toward solving the long-term climate issue. Are we recommending continued investments in those fossil fuel companies? Not necessarily. But we do believe greater levels of transparency in the nuances of ESG scoring—in addition to greater levels of nuanced control of underlying holdings and filters—are necessary to solving the problem.

Control is the key. Whether the mandate is ESG, tax efficiency, or a specific risk or exposure mandate, having full control at the total-portfolio level is the critical first step to implementing a custom program easily and efficiently.