ESG Investment: Enhancing transparency and trust

A decade ago, most asset managers would not have contemplated screening their investments to ensure they were in line with ESG (environment, social, governance) principles, mainly because it was not a priority for the majority of their underlying institutional or retail clients. It was also assumed that ESG investing came at a cost, as it limited the universe of securities in which managers could invest.

Attitudes are rapidly shifting as more institutional investors start incorporating sustainability metrics into their fund selection criteria. At the same time, empirical data would suggest ESG focused investing actually advances the bottom line rather than hampers it. In response, fund managers are increasingly applying ESG into their portfolio construction.

According to McKinsey, ESG investments now account for around 26%, or $23 trillion of the $88 trillion in global AUM. These flows are unlikely to change course, added McKinsey, with ESG being integrated into portfolios at a growth rate of 17% per year, something which has been abetted by the strong performance of the asset class relative to traditional benchmarks.

A recent report produced by the Cayman Alternative Investment Summit, in conjunction with AIMA, noted that increasing investor demand for responsible investment was one of the biggest trends shaping the global asset management industry today. The report also found that 36% of the 80 hedge funds surveyed had become signatories to the UN Principles for Responsible Investment (UNPRI) organisation, adding nearly a third of firms had hired a responsible investment expert or plan to do so in the next year.

Increased institutional focus on ESG will lead to demand for services that improve transparency and accountability, which build confidence and trust in how managers implement ESG into their processes. Such solutions are much-needed and in demand amid concern that some firms are guilty of greenwashing their portfolios, an activity which threatens the very credibility of ESG asset management.

Managers can demonstrate their ESG credentials to clients by enhancing internal controls and governance, or through appointing service providers offering assurance solutions. Service providers – including data providers, custodians, fund administrators and depositaries – are starting to recognise that ESG presents a commercial opportunity.

Some providers are already developing their own reporting and measurement products enabling managers to demonstrate to clients that they are in compliance with their ESG investment mandates.  Depositaries, including those prescribed under the EU’s Alternative Investment Fund Managers Directive (AIFMD), have a long track record of verifying that managers – running a diverse range of strategies – are complying with their investment mandates.

This puts depositary providers in an excellent position to monitor ESG assets in managers’ portfolios, and report back to fund boards on whether there have been any material breaches, something which could help mitigate reputational risk at the client-level.  Those depositaries with deeply entrenched, multi-asset class coverage and experience are particularly well-placed to support ESG managers, many of whom run wholly unique strategies (such as exclusionary, direct investing into sustainable assets, etc.). ESG oversight could therefore be a natural extension of the depositary’s existing service offering.

The role of depositaries in ESG monitoring could also be enabled by changing regulation. Regulation and guidance from international bodies such as the Financial Stability Board (FSB) through its TCFD (Task force on Climate Related Disclosures) initiative are encouraging companies such as asset managers to become greener and more environmentally responsible across their operations.

In May 2018, the European Commission published a number of proposals on sustainable finance which will impact all EU based investment managers. The proposals will require managers to publish policies on their websites on how they integrate ESG factors into their investment decision-making processes along with evidence demonstrating compliance.

The regulation will also establish criteria for determining whether an economic activity is environmentally sustainable and will introduce low-carbon and positive-carbon impact benchmarks. The consultation period has recently ended and could be adopted by the European Parliament in mid-2019 with implementation over a transition period into 2020.

The increasing industry focus on ESG coupled with changing rules which prioritise and encourage sustainable behaviour could result in depositaries being entrusted by regulators, fund directors and investors with ensuring that managers are ESG compliant. Having successfully delivered on AIFMD and UCITS, depositaries may begin to transition into ESG oversight.

This INDOS Financial article was first published in HFM Week.