Enhanced Oversight: How we assess and address ESG risks

One need not look far to see ESG (environmental, social and governance) risks materialise as financial impacts in the real world. Most recently, the turmoil left by Hurricane Ian has created alarming headlines about the potential collapse of Florida’s insurance market – a risk which could be felt by millions of families living in the state. While the magnitude and timing of ESG-driven financial impact can be hard to predict, asset owners and asset managers are increasingly focused on identifying and avoiding these risks where possible.

 

Meanwhile, regulators are scrutinising the claims made by asset managers when it comes to responsible investing practices and ESG assessment processes. This combination of client expectations, regulatory interest and investment risk has heightened the need for asset managers to maintain a consistent and diligent approach to managing ESG risks. 

 

This is why we believe that the best asset managers should have a thorough and comprehensive approach in place that identifies and mitigates ESG risks. For example, at Russell Investments, our approach is guided by our sustainability risks policy – and we’ve named a critical part of this strategic process Enhanced Oversight.

 

What is Enhanced Oversight?

 

Enhanced Oversight is the process by which our portfolio management teams actively assess ESG risks in funds and explain how those risks are being monitored and managed. 

 

Enhanced Oversight happens each quarter, and it begins with portfolio managers conducting a quantitative assessment of the ESG risks within their funds. Not all ESG risks can be identified using data, but it is a practical starting point, particularly for equity funds. Some of the data we consider as potential indicators of ESG risks include (on a company-by-company assessment):

 

  • Compliance with the UN Global Compact and other international norms and standards
  • Greenhouse gas emissions intensity vs. peers
  • Gravity and quantity of social-related controversies (e.g., labour disputes or data privacy breaches)

Because we want to focus our attention on the most material risks, our portfolio managers also take fund weight into account. Larger positions are more likely to receive extra scrutiny in this and later stages of the process. Of course, the portfolio managers make appropriate adjustments depending on the type of fund. For example, if the fund has a low-carbon mandate, then the investment team will focus on the higher-emitting companies even if our ownership level is minimal.

 

Next, our portfolio managers conduct a qualitative assessment of the identified companies. Because of the nature of ESG data (more on this below), the risks indicated by the data may already be well understood and accounted for in the price of the security. In some instances, we may already be engaging in conversation with the company to advocate for practices that mitigate risk and enhance opportunity. In other cases, we will seek more information, often from our internal responsible investing analysts but also –and more importantly – from our subadvisor partners.

  

The details on assessing sustainability risks

Russell Investments is a manager-of-managers, so while we retain full fiduciary responsibility for our assets managed in house, we rely on the best-of-the-best subadvisors for active security selection. Based on this model, we also leverage our sub-advisor partners to further assess sustainability risks in our funds. After we’ve conducted the quantitative and qualitative ESG analysis described above, we use our system of quarterly check-in calls with sub-advisors to discuss the ESG risks of specific holding companies. 

 

We consult our sub-advisor partners with two key aims:

  1. Confirm the ESG risk
    ESG data is notoriously backward-looking, meaning that what is quantitatively flagged as a material risk for a company might not still be the story when we’re taking a forward-looking view via Enhanced Oversight. Our sub-advisors serve as the subject matter experts on companies in our fund, and we can utilise that expertise to examine the accuracy of the data and determine if steps have already been taken by the company to mitigate the issue being discussed.

  2. Assess engagement potential
    As an active owner of our holding companies, Russell Investments uses engagement as a means for risk mitigation and finding value-creating opportunities. We use the Enhanced Oversight process as one means to identify target companies for engagement that we expect will allow us to potentially move the needle on ESG issues. In other words, we identify a risk in company operations or practices that we believe active dialogue can help mitigate. 

While we conduct our Enhanced Oversight process on a quarterly basis, not every sub-advisor will be questioned on ESG issues each quarter. This is due to the long-term lens with which we assess ESG risks. The issues in question might have a change horizon of five to ten years – meaning, if we’ve discussed the sustainability risks of a company with our sub-advisor in one quarter, the possibility that events have changed by the next quarter is low.

 

ENACT

 

Through Enhanced Oversight, our teams collect and generate meaningful insights about the operations and risks of our investment companies. These insights are of immediate value, but also inform our views across teams and through time. As noted above, they also serve as a critical input to our active ownership program, influencing our engagement efforts and proxy voting decisions. To maximise the information capture and transfer, we’ve developed a proprietary tool that we named ENACT, an acronym derived from the terms ENhanced Oversight and ACTive Ownership. ENACT allows us to log the insights we gather from the Enhanced Oversight process alongside our engagement actions, per company and across our funds.

 

For example, two teams might hold the same company via different subadvisors and in their respective funds, e.g., an emerging markets fund versus a global fund. ENACT allows the emerging market team to see that the global team discussed the company during the Enhanced Oversight process and gathered insights on material ESG issues that weren’t fully explained by the ESG data. The emerging markets team can then use that insight in its own qualitative assessment of the company. ENACT provides a holistic view of the actions taken across strategies to assess and respond to ESG risks. 

 

The bottom line

 

We see our approach as both iterative and looping, as Enhanced Oversight provides our portfolio management teams with a structured method for assessing ESG risks in our funds. This informs our corporate engagement program which, in turn, generates insights and outcomes that enhance our oversight process.

 

Ultimately, we think that ESG risks will continue to materialise into present-day financial impacts caused by environmental disasters, social upheaval, and macro-global trends. Amid this backdrop, we believe that the best active managers will have a careful and consistent process in place that helps to identify and manage complex real-world risks that impact investment outcomes.