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14 April 2008
Taking a responsible investment approach to alternatives
Source: www.globalpensions.com
by David Russell and Danyelle Guyatt 11 April 2008
David Russell and Danyelle Guyatt take a look at the incorporation of ESG issues into investment in alternatives and suggest a number of action points for pension funds
As global investors seek alternative beta exposure to enhance portfolio return and diversification through increasing allocation to alternatives, the Universities Superannuation Scheme (USS) and Mercer joined forces to consider the possible link between how these goals can be pursued by mainstream investors in a way that is compatible with responsible investment (RI) policies and practices.
RI, defined in its broadest sense, is the lengthening of the investment horizon and the integration of extra financial factors such as Environmental, Social and Governance (ESG) issues into the investment decision making process. It is timely to consider the link between RI and alternatives for the following reasons:
* First, increased allocation to alternative assets by institutional investors brings with it increased risks in terms of poor transparency and governance standards of many of the investment vehicles. Allocating to these assets as a long term responsible investor can therefore be prudent practice for fiduciaries, to consider the wider risks and investment opportunities associated with their exposures;
* Second, we believe there is a relatively high level of sophistication and familiarity with RI implementation in traditional listed equities (via negative screening, positive screening, integration into valuations and activism via voting and engagement). In contrast, there are few examples to draw from in terms of best practice implementation of RI policies and practices across alternative investments;
* Finally, there has been significant growth in the numbers of signatories to the Principles for Responsible Investment (PRI), one of the aims of which is to integrate the consideration of ESG factors across all asset classes.
It is therefore timely for signatories to consider how they can best maximise returns of their alternative investments in a way that is compatible with their policies to invest in a long term responsible manner.
Case studies on PRI signatories
As part of this project, Mercer evaluated the policy and approach of a number of PRI signatories in terms of their approach to integrating ESG factors into their alternative investments. These organisations represented asset owners, asset managers and insurance companies that span the US, European, and Australian markets. The asset classes included property, infrastructure, private equity, hedge funds, and commodities.
In addition to the evaluation of the five funds, desk-based research was conducted on the link between ESG factors and each alternative asset class, including identifying the investment risks and opportunities through an RI lens. The key findings of the study were as follows:
* There are very few examples of integration of RI policies into alternative asset allocations, i.e. these issues appear to be taken into account rarely in traditional alternative asset investments and investment processes;
* Investment in this space is primarily carried out via ‘themed’ funds, rather than integration into mainstream mandates;
* Small group collaboration amongst institutional investors with compatible investment objectives has emerged as an innovative way for investors to access private equity markets in a cost effective manner that also meets their broader RI investment criteria;
It would appear the integration of extra financial factors into alternative asset allocations is at an early stage of development, with little evidence that it is being implemented.
Whilst themed funds offer some exposure to RI related issues, mainstream asset owners do not necessarily invest in such specialised funds and many are unlikely to gain exposure via this route.
Those asset owners trying to integrate these issues into their core allocation to alternatives face a significant challenge, but we believe this is not insurmountable.
Themed funds as source of alpha generation and beta enhancement
Is the allocation to alternatives via themed funds the equivalent to more traditional negative screen based ethical investing? We believe such themed funds provide one potential route for allocations in this area.
The approaches adopted by some of the managers of alternative asset classes provide potentially strong sources of alpha and beta diversification. Importantly, they are ‘value-driven’, not ‘values-based’. This is an important distinction and one that separates the majority of themed alternative strategies from “ethical” listed equity based funds.
Some of the investment risks and opportunities and the types of strategies that we have seen emerge across each alternative asset are summarised in the table below. The main point to note is that many of these themed investment vehicles actually view extra financials (the E, S or G factors) as value-drivers for portfolio returns over time. Investment opportunities are therefore evaluated and selected on the basis of how well they fit with the philosophy and investment approach of the strategy, as well as their risk/return characteristics.
Systemic challenges for the responsible long term investor
Whilst there are investment opportunities for those wanting to undertake themed investments in this area, there are, unfortunately, systemic challenges for long term responsible investors seeking to genuinely integrate their RI philosophy across alternative investments, some of which include:
* l Poor transparency - the governance and fund transparency of many alternative investment vehicles has traditionally been low (from a traditional asset owner / public equity perspective), as a result of differing corporate governance requirements and expectations. This adds to the challenge of integrating disclosure on ESG integration into the investment process, as reporting by portfolio holdings at all levels (both internally and externally) can be poor. Hopefully, the recent Walker consultation and guidance will improve transparency for UK and potentially other markets (www.walkerworkinggroup.com);
* Lack of size and power - it is often difficult for asset owners as Limited Partners to individually influence mainstream alternative asset managers/General Partners and to encourage integration of extra financial factors into core investment management processes;
* Credibility and reputation - there could be a risk that those institutional investors who request integration of an RI approach into mainstream mandates might be perceived as lacking in credibility by alternative asset managers. In an environment where investors are potentially competing for access to limited investment opportunities, this could prove to be a challenge for the placement of assets and hence needs to be managed and simplified to a few ‘key messages’;
* Sector awareness - there is a lack of awareness amongst many alternative asset managers about RI and ESG issues, what they mean, and what asset owners want in terms of integration. In contrast to listed equity markets, where knowledge of responsible investment has developed somewhat over recent years, alternative fund managers are less experienced and aware of the wider expectations of asset owners with respect to these issues.
There is therefore a need for such investors to be clear in their policies, approach, and expectations, and to convey this clearly to asset managers in their discussions.
Solutions and action points for institutional investors
Having set out some of the challenges, we have also given consideration to some possible solutions, such as:
* Clarify policy and expectations - develop a policy towards integration of extra financial issues to clarify expectations for asset managers. This can be either a generic policy or one for each alternative asset class;
* Communication with fund managers - incorporate fund requirements into the deliberations of alternative allocations. This could be either via the setting of mandates or through fund due diligence processes, and could focus on the following three areas:
1. Seek positive environmental management and best practice standards associated with investment opportunities both in any due diligence discovery process and also in management of assets;
2. Ask for clarification as to whether stakeholder expectations have been considered and managed in the project/investment planning, including human capital management and impact on local communities;
3. Seek full transparency and disclosure of the investments held in the fund and seek high standards of fund governance.
* Industry collaboration - signatories to the PRI represent a substantial pool of assets that, collectively, is working to enhance awareness and standards across markets. Indeed, the PRI has a programme in place to look at developing a framework for responsible investment for the global private equity sector. In addition, a number of pension fund members from the Institutional Investors Group on Climate Change (IIGCC) recently met with private equity funds and their representative bodies to discuss how exposure to the cost of carbon and climate change could be built into private equity investments;
* Small group collaboration - institutional investors can seek small regional, or cross-regional, collaborative opportunities with like-minded institutional investors to establish a cost effective method to allocate funds to alternative assets in a way that is consistent with RI goals and objectives (the Alpinvest vehicle set up by ABP and PGGM is a good example of this).
To conclude, whilst there are some good investment opportunities via ‘themed’ strategies that potentially meet RI and risk/return objectives, we note that the industry is still at an early stage of development in terms of RI/ESG integration into mainstream strategies.
Over the medium to long term, there are options available to promote integration into alternative investment vehicles, both through collaborative ventures as well as via direct discussions with fund managers of these vehicles. Mercer encourages asset owners to consider taking these steps to ensure the growth in asset allocation to alternatives is implemented in a way that is compatible with a fund’s wider RI goals and objectives.
Likewise, we urge asset managers in the sector to consider the broader systemic issues that impact on the risks - and opportunities - associated with many alternative investments and to make efforts to integrate these in their mainstream processes. USS supports this advice: after all, good governance, transparency, and evaluation of stakeholder expectations and environmental practices are all about doing good business and therefore making investment returns to pay pensions over the long term.
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Sustainable Investment Research Platform
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