How U.S. institutional investors can practically incorporate more ESG into their portfolios
6-year-olds and healthy food are like my New York Mets and championship success—they don't really like to party together, and it's a constant source of frustration for me. That said, the difference is that I have some control about my son's eating habits. Over the past year, I've found that the real struggle in this journey has not been to get him to understand why it's important to eat healthy or what foods are healthy, but how to eat healthy.
We're at the same stage in getting ESG investments into U.S. institutional investment programs. Many fiduciaries acknowledge and believe in why ESG investing is important—the benefits to investment returns, the reduction to investment risks, the potential alignment of the portfolio with an organization's vision, etc. Further, many investors may also understand what ESG incorporation methods are out there—negative exclusions, positive screening, ESG factor integration, or impact investing, just to name a couple. But now the real struggle is how do you begin to incorporate ESG into your portfolio?
The first step would be to define your beliefs around ESG, and based on that, decide how much ESG you want to incorporate. This is a decision that should be guided by you and your organization's beliefs and goals regarding ESG, your comfort with what has been a shifting regulatory arena and your capacity for implementing different solutions. We have focused on the following methods of ESG incorporation, in order of implementation ease:
- Active ownership through proxy voting and/or company engagement
- ESG integration: Consideration of manager's ESG credentials in manager selection and oversight
- Incorporating negative ESG exclusions or positive ESG screens
- Hiring impact or sustainable ESG managers
We have developed best practices on how to incorporate each of these methods. Of course, each investor is unique and each of these implementation options should be tailored to meet each organization's specific needs and situation.
Active ownership through proxy voting and/or company engagement
Call this one whole wheat pizza with veggies. Healthier, not the healthiest, but importantly, a step in the right direction—and plenty of pizza shops will make it for you! In a similar vein, active ownership, whether through proxy voting or company engagement, is generally regarded as an effective mechanism to reduce ESG-related risks, maximize returns and have a positive impact on society and the environment. And like ordering from the pizza shop, the good news is that it's also relatively easy to implement as well.
For those organizations whose portfolios are outsourced to an OCIO provider or only have investments in external managers through commingled vehicles, it's crucial to discuss with the provider and/or managers to assess their capabilities to robustly handle proxy voting and company engagement. You may want to discuss your committee's views on key proxy items and company engagement topics. At the end of the day, the provider and manager are responsible for the process and execution of proxy voting and/or company engagement.
For those that have direct control over some to all of their holdings, either by utilizing separate accounts with external managers or managing their own assets, proxy voting and/or company engagement can be a full-contact sport. Depending on bandwidth, you can hire a proxy voting firm or stewardship service provider to focus your staff on only the most crucial ESG items, or you can assign staff to handle the tasks associated with proxy voting.
Consideration of manager's ESG credentials in manager selection/oversight
For my son, this one is not about cutting anything out completely, but making sure we include high-quality ingredients whenever possible. Similarly, on the ESG side, think of this method as not limiting the investable universe of managers, but instead ensuring that you only hire high-quality money managers that appropriately incorporate ESG factors, among many others, into their process. You will want to make sure your investment consultant or OCIO provider has a clear methodology to understand how much ESG factors matter for a manager's process and a way to assess each manager's ESG capabilities, including the manager's:
- Commitment to ESG at the organizational level
- Consideration of ESG within the investment process
- Integration of ESG into actual portfolio decisions
- Active ownership with portfolio companies to drive meaningful change
Understanding how important ESG is to a manager's process, and then being able to assess these ESG factors into your manager selection and oversight processes, will help to incorporate more ESG elements into your plan—with the potential for improved returns and lower risk.
Incorporating negative ESG exclusions or positive ESG screens
Hiding the candy and showcasing the fresh fruit—this one is what to exclude and include in your kid's dessert. From an ESG perspective, some organizations may have specific beliefs on how to improve portfolio performance and/or align with your organization's views by excluding or including certain stocks for ESG reasons. Common exclusions may include environmental activities (e.g., animal testing or fossil fuels), governance practices (e.g. corruption levels), and social issues (e.g. gambling or tobacco).
Meanwhile, common positive ESG screens—or factors that you may want to have more exposure to—could be stocks of companies that are expected to benefit from a transition to renewable energy or that have high employee satisfaction scores. Three ways of incorporating these exclusions or positive ESG screens are:
- For commingled fund managers, you want to choose managers that incorporate the exclusions or positive ESG screens that you want. However, ensuring uniform exclusions or screens across all managers may be difficult, since even ESG-conscious managers are likely to have small differences in what stocks they include or what screens to utilize.
- For separate account mandates, you can often work with a manager to incorporate negative exclusions or positive ESG screens. However, not every manager has the capabilities to do so, in which case another option may be to utilize a separate implementation manager to handle incorporating these exclusions or screens.
- For OCIO mandates, make sure your provider can incorporate ESG exclusions or screens. An OCIO provider could overlay these exclusions or screens on top of any external manager portfolios or may be able to include managers that incorporate these exclusions or screens.
A key factor here is to make sure your manager/OCIO provider/implementation partner has the capabilities to effectively understand the impacts of specific ESG exclusions and also to implement the ESG exclusions and/or screens you want. For example, any exclusions by carbon footprint could result in unintended consequences of underweighting those companies that are making significant strides in energy transition, which would compromise the benefit on ESG incorporation in the first place.
Hiring impact or sustainable ESG managers
Our family partakes in meatless Mondays, where Mondays focus on eating fruits and vegetables instead of meat. This was tough at first, but over time, it's helped my son better appreciate vegetables. By the same token, hiring impact or sustainable ESG managers is also probably one of the more difficult options to implement when it comes to bolstering your ESG incorporation efforts—but it's also likely the best way to move the needle more toward ESG in your investment plan. To hire impact or sustainable ESG managers, we believe an investor should do the following:
- Determine what theme(s) they want to target, likely aligning with the organizational beliefs (e.g., green energy, health care access, low carbon, etc.)
- Determine what types of funds they would like to utilize (e.g., sustainable public equity funds, private equity funds, impact investment funds)
- Find and hire best-in-class managers that meet the theme(s) and fund structures as laid out in steps 1 and 2
Needless to say, this can be a lot of work! Working with an informed and experienced investment consultant or OCIO provider with capabilities to help guide these steps is absolutely crucial.
The bottom line
These general best practices on how to incorporate more ESG into your investment program should obviously be tailored to your specific beliefs, circumstances and reporting capabilities. However, concerns about how to incorporate more ESG should not stop any institutional investor from gaining the multitude of potential benefits of greater ESG incorporation. Work with your external asset managers, investment consultant and/or OCIO provider to find the best path forward that meets your needs.
For many U.S. institutional investors, it probably makes sense to incorporate more ESG using a combination of the methods above. In addition, with the changing landscape in the U.S. toward ESG investing, new ways on how to implement more ESG in portfolios will assuredly pop up over the next few years. I, for one, am excited to see what new techniques are developed—just as I'm also open to your ideas on how to make my son a healthier eater!