Long-term responsible investing literature review

The table includes a collection of literature (reports, presentations, books and principles) that present the case for longer-term investing. A few of the most relevant pieces of literature have been summarised. The summaries may only contain selected sections form the main text that have been deemed most relevant for long-term investors. The links to the full text have been included for your reference.

If you believe there to be relevant pieces of literature that are not included in the below table, then please contact Will Martindale.

 

Title Author Date
Avoid the Agg Drag
Cambridge Associates 01/07/2014
Long-Term Mandates
PRI 01/07/2014
Curbing Excessive Short-Termism
Global Network of Director Institutes 01/05/2014
Proving Incentives for Long-Term Investment by Pension Funds The World Bank 01/05/2014
Coping, Shifting, Changing: Strategies for Managing the Impacts of Investor Short-Termism on Corporate Sustainability UN Global Compact 01/05/2014
The Value of Responsible Investment: The moral, financial and economic case for action Investment Leaders Group 01/05/2014
Hallmarks of Successful Active Equity Managers Cambridge Associates 01/04/2014
Earnings Guidance: Part of the Future or the Past? Generation Foundation 30/01/2014
Focusing Capital on the Long Term HBR, Dominic Barton, Mark Wiseman 01/01/2014

Click here for summary

This report explores the action required to combat short-termism, placing the onus on large asset owners to act. Through the use of positive examples it describes the benefits of shifting the focus of the system towards a longer-term view.

The authors seek to explain the gap between knowing the right thing to do and acting on it, which is highlighted by research from McKinsey and the Canada Pension Plan Investment Board (CPPIB) in a survey of more than 1,000 board members and C-suite executives around the world to assess their progress in taking a longer-term approach to running their companies. The authors own survey showed that 46% of respondents said that the pressure to deliver strong short-term financial performance stemmed from their boards, whilst board members stated that they were often channelling increased short-term pressures from investors.

The report highlights the negative effects of the major asset owners in taking a short-term approach which can result in management making suboptimal deci¬sions for creating long-term value. It also stresses that short-termism is undermining the ability of companies to invest and grow, with missed investments having far-reaching con¬sequences including slower GDP growth, higher unemployment, and lower return on investment for savers.

The authors have suggested four practical approaches for institutional investors that are serious about focusing more capital on the long term.

  1. Invest the portfolio after defining long-term objectives and risk appetite.Singapore’s sovereign wealth fund, GIC, maintains a publicly stated 20-year horizon for value creation. The fund has deliberately pursued opportunities in the relatively volatile Asian emerging markets because it believes they offer superior long-term growth potential. This has meant that during developed-market booms, its eq¬uity holdings have underperformed global equity indexes. While the board looks carefully at the reasons for those results, it tolerates such underperformance within an established risk appetite.
  2. Unlock value through engagement and active ownership.For companies that the California Public Employees’ Retirement System (CalPERS) worked closely with, collective returns exceeded industry benchmarks by 12%.
  3. Demand long-term metrics from companies to change the investor-management conversation.Puma has recognised that its sector faces significant risks in its supply chain so it has published a rigorous analysis of its multiple tiers of suppliers to inform investors about its exposure to health and safety issues through subcontractors.
  4. Structure institutional governance to sup¬port a long-term approach.Norges Bank Investment Management (NBIM) kept to its coun¬tercyclical strategy and bought into the falling equity market of mid-2011, turning an equity loss of nearly 9% that year into an 18% return in 2012.
Building a Long-Term Shareholder Base Generation Foundation 01/12/2013
Now for the Long Term Oxford Martin School 01/10/2013
Green Light Project Share Action 01/10/2013
Ten Strategies for Pension Funds to Better Serve Their Beneficiaries Keith Ambachtsheer 28/09/2013
Stock Duration and Misvaluation Martijn Cremers, Ankur Pareek, Zacharias Sautner 19/09/2013
From financed emissions to long-term investing metrics – State-of-the-art review of GHG emissions accounting for the financial sector 2 Degrees Investing Initiative 01/07/2013

Click here for summary

With regards to Scope 1, 2 and 3 Greenhouse Gas (GHG) emissions, the review reveals a diversity of approaches for dealing with them. From a risk and performance perspective, a non-inclusive approach to scopes can mislead investors.

The authors suggests that lifetime emissions accounting makes more sense than annual emissions accounting, as investors are likely to be concerned about future regulation increasing the cost of future emissions, which may lead to a loss in profitability, impairment or litigation. Life time accounting is also much more applicable when it comes to tracking ‘climate performance’.

Generally investors can either report on the footprint of their stock of assets or the impacts of the transactions incurred (cash-flow accounting). Time boundary issues exist for both. Stock-based accounting raises several questions, namely that long-term investments are being accounted for in the same way as short-term ones even if both influence and risk exposure are different.

Some assets (e.g. derivatives and repurchase agreements) are difficult to link with investments in the real economy, but may also finance emissions. The priority of projects and listed equities by most practitioners seems to be driven by the availability of primary carbon data and the clients’ motivations, rather than a detailed review of risks and levers for change from an investor’s perspective – a more comprehensive approach is needed.

Carbon data providers estimate GHG emissions with statistical models, however the frequency of updates is a key concern as the information provided to the final investor may be up to three years old. However, from an end user perspective, the annual financed emissions indicators are used in most cases as a proxy of either carbon risk or performance (which are connected to future / past emissions), reducing the need for current data.

The report explores the potential of financed emissions to be used as a basis for the development of carbon risk indicators. Regulation would require the introduction of long-term stress tests to cover point-in-time risks at company or financial institution level. It is assumed that assessing the full spectrum of carbon risks makes most sense.

  • The case of non-financial organisations – The best practices are based on a stress test of specific scenarios for a specific industry conducted on an ad hoc basis. Data required to assess the carbon risk exposure of a company includes the carbon intensity of activities (scope 1, 2 & 3), the time dimensions of carbon risk (past, annual and locked-in emissions), the exposure to regulation and litigation, and the capacity to adapt to new policies.
  • The case of financial organisations and diversified portfolios – At portfolio level, most quantitative approaches are based on a price set on consolidated financed emissions and do not distinguish the type of regulatory or litigation risks they face. One of the key weaknesses is that once data is aggregated at the portfolio level, it loses its ability to inform risk assessment.
  • Next steps – The current approach for portfolios is not robust enough to inform risk management. A few alternative approaches are identified based on asset-classes scoring not financed emissions.

The report analyses the possibility to use financed emissions data to build a carbon performance indicator(s), to manage the carbon performance of the portfolio and reporting results in order to inform choices. Carbon performance is defined as the contribution (positive or negative) to financing the transition to a low-carbon economy, focusing on mitigation rather than adaptation. Performance indicators should allow users to; 1) benchmark diversified portfolios; 2) set performance targets for inclusion in mandates and bonus schemes; 3) optimize the carbon footprint while continuing to finance the economy; 4) link performance with climate policy goals (2° scenarios). To be effective, these indicators should fit in investment processes (which are described in the report).

  • Defining a relevant denominator – To date most performance indicators based on ‘financed emissions’ measure the carbon intensity per $. However the use as a performance indicator is limited.
  • Best-in-class – Carbon intensity per $ can be misleading for certain industries. In those cases, fund managers use industry-specific indicators to inform best-in-class selection (for example carbon emissions per km for automotive manufacturing).
  • Allocation – At portfolio level, the carbon intensity per $ cannot distinguish a ‘low-carbon’ portfolio built with non-industrial assets (e.g. software) and another portfolio composed of low carbon part-of-the-solution industries (e.g. renewables). This is a major obstacle for the use of financed emissions as they can only inform divestment decisions, not reinvestment decisions.
  • Net emissions – To overcome this obstacle, various banks track the ‘net emissions’ calculated at project level by comparing the project footprint (e.g. for a wind farm) with the footprint of baseline scenario (e.g. a coal-fired power station). However, limitations exists when the investment includes several industries and countries, as the concept of baseline scenario is difficult to establish.
  • Selecting the appropriate benchmark – Most managers using financed emissions data benchmark their fund against a stock index to assess the ‘emission reductions’ of their portfolio. Doing so they use the index as a ‘baseline scenario’. The report suggests this approach may be misleading (e.g. the sector exposure of most stock-indices used as benchmarks is strongly biased toward fossil fuels compared to the real economy).
  • Next steps – The current state of methodologies requires additional qualitative analysis to optimize the footprint in a meaningful way. Research is needed to define a denominator and benchmarks reflecting the industry weighting in the long term investment needs of the real economy.

To assess climate performance or risk, investors need forward-looking data, as well as ‘integrated performance’ indicators; 1) forward-looking activity data; 2) locked-in GHG emissions and; 3) Point-in-time risks stress-tests (companies with high carbon risk exposure need to conduct climate stress tests on long-term carbon risks).

Long-Term Financing of the European Economy: Green Paper European Commission 25/03/2013
Geneva Summit on Sustainable Finance Zacharias Sautner 19/03/2013
A dialogue on the role of business Pr Yvan Allaire 22/01/2013
Carrots and Sticks: Promoting Transparency and Sustainability UNEP / GRI 07/11/2012
Government Response to Kay Review Rt Hon Dr Vince Cable MP, BIS 01/11/2012
The Consequences of Mandatory Corporate Sustainability Reporting Ioannis Ioannou and George Serafeim 26/10/2012
From Short-Term Salesmanship to Long-Term Stewardship 300 Club, Lars Dijkstra 22/10/2012

Click here for summary

This paper discusses the shift that has occurred over the past thirty years in asset management, from a client-driven approach to a product driven approach. The author suggests that asset management in its current form does not add value to clients and confirms the need for a paradigm shift in the industry towards long-term stewardship.

This paper contains an analysis of developments on the client side, as well as on the supply side. The following is discussed; pension boards being confronted with increasing complexity, higher competencies required for the board of trustees, the short-term focus on behalf of both asset managers and clients, and the need amongst pension boards to be more in control. Some interesting observations are noted including a study by Molenkamp and Van Welie, showing that governance can be taken to extremes causing a dramatic rise in costs without the benefit of increased effectiveness. Other observations include that accounting and regulation is increasing the short-term pressure for Boards of Trustees. Similarly, ‘me too’ behaviours from Trustees who are overly fixated on peer risks and reputational risks are increasing short-termism. The author also suggests that clients have become fixated with benchmarks leading to a short-term, budget focused, mind-set instead of focusing on maximising long-term real returns.

Next, the position of asset management in 2012 is discussed, concluding that on average the industry fails in three aspects; expertise, discipline, and reliability. In the author’s view there are three main causes; 1) financial conglomerates, 2) a lack of focus and 3) short-term career risk. With regards to financial conglomerates, it is noted how the global trend of ‘bigger is better’ has led to tremendous consolidation. A study by Cremers and Petajisto, of Yale University found that the more assets an investment fund had under its management, the worse the long-term results. The author goes on to outline how large firms are driven by a product focus and profit motive rather than a client focus, with such firms marketing funds that appeal to the public (in many cases this involves marketing yesterday’s winner). When discussing career risk the author argues that the primary focus of managers running asset management firms is on the short-term interests of their shareholders and in wanting to secure their bonus and job, are less inclined to take risks that may add long-term value for the client.

In describing the move towards long-term stewardship this paper suggests that the asset management industry should be client-focused, with long-term aims. The need to move away from distribution, marketing and product pushing is stressed. The author states that superior asset management requires creativity (mainly a matter of art and science) and decisiveness (determined by culture). To realise this, three conditions have to be met; 1) alignment of interests between clients, asset managers and employees, 2) focus and 3) long-term commitment on the part of client and asset manager. The results of a study by John Bogle demonstrate the benefits in aligning interests, showing that mutual funds of employee-owned asset management firms deliver better long-term investment returns than mutual funds managed by large financial conglomerates. Results of the same study also reveal the importance of focus, showing a negative relationship between the number of investment strategies pursued by an asset manager and the results (the fewer investment funds the better). The author goes on to discuss long-term commitment, stating that the current obsession with benchmarks undermines investors’ long-term real return objectives and suggests a value approach across a wide range of assets as an alternative, requiring patience and a willingness to be contrarian.

The author concludes with a list of requirements for both asset managers and investors alike, stating that asset managers and their clients both have a responsibility to reinvent themselves and the way they work together, with each partner showing 100% commitment.

Towards a More Inclusive Capitalism Henry Jackson Initative 18/10/2012
We need a bigger boat Towers Watson 01/09/2012

Click here for summary

This paper argues that the portfolios and strategies we judge as well-suited to present-day conditions will prove unsuited to future conditions and states that investors who have previously been able to ignore these factors or react to changing conditions, run a significant risk that their performance will not be sustainable into the future.

The authors consider sustainable investing in its broadest sense incorporating environment, social and governance (ESG) but going beyond to consider the large inter-generational issues that institutional funds need to take into account. They define sustainable investing with the integration of three concepts; 1) long-term investing; 2) investment efficiency (maximising returns after allowance for risk) and; 3) inter-generational soundness. It is argued that the concept of sustainability in investment is concerned with strategies that are designed to be effective in the short and long term, recognising linkages between the short and long term.

The authors believe it to be likely that the world is entering a period of significant change in world economies, politics and capital markets, which will fundamentally affect the landscape facing institutional investors. It is argued that a number of interconnected issues are arising, converging to produce transformational change, for example the degradation of natural capital and changes in demography (see full text for more examples). With this in mind, the authors argues that the innovation model (where institutions make breaks with past practices and policies and employ significant commitments to change management to embed lasting change) is likely to be the most effective in delivering a sustainable investment outcome.

Research is drawn on by Oxford University, in which several interesting points are outlined. Professor Myles Allen has identified three areas that investors should be concerned about; 1) the impact of long-term predictable consequences (e.g. rising sea levels); 2) the impact of unpredictable, global-scale climate discontinuities (e.g. irreversible deforestation) and; 3) the impact of extreme weather events. He also suggested that when investors consider the implications of climate change, they underestimate the risk of companies and sectors being deemed liable for the effects of their actions. Dr Dariusz Wójcik and Sarah McGill stated that the effects of climate change on the atmosphere and water scarcity are the most urgent issues, with biodiversity, food and agricultural land on the list ahead of various metals, oil and gas. They argue there is an early-mover advantage for sustainable investors and also noted the need for a collaborative approach to address the issues. Dr Claire Molinari has argued that sustainable investing, when defined and approached correctly, helps to meet the fiduciary obligations of loyalty, prudence, diversification and impartiality.

The response likely to be needed in the face of change is also discussed. It is stated that dealing with such change and benefiting from it financially will require; a better understanding of the emerging realities associated with long-term issues such as climate change and resource scarcity; innovation in investment policies and instruments to exploit these issues as opportunities; and evolving governance structures that support more effective decision making. An emphasis is also placed on asset owners to anticipate change and plan for its consequences, rather than simply being reactive as events unfold. There are three key considerations; 1) risk and uncertainty, 2) the impact of externalities (spill-over effects of production or consumption that produce unpriced costs or benefits to other unrelated parties) and; 3) time horizon (short-term periods do not adequately allow for the possible long-term impact of externalities). This paper sites the UNPRI in estimating that the total cost of some of the most important negative externalities for listed companies exceeded $2.5 trillion in 2008.

In this paper a road map for sustainable investing is put forward. The primary user would be the decision maker, however its use is also relevant for stakeholders in order to identify and track progress. This approach incorporates consideration of ESG issues as these are elements of risk and reward. The goal is for the long-term outcome to be better financial performance, adjusted for risks and costs, and providing inter-generational fairness. The road map is a multi-year plan and the attributes are listed below:

  • An achievable plan that meets the needs of all stakeholders.
  • Starting position. (Which includes a recognition of essential work to be done in clarifying mission and goals before being able to consider the implications for investment portfolios).
  • Target destination. (This is a framework that supports decision making under uncertainty).
  • A plan for how to get from the start to the destination.
  • What ‘tools’ will be needed.
  • How to adapt to events along the way.
  • Milestones, ways for stakeholders to measure progress.

The authors state that sustainable investing requires an evaluation of a fund’s values and investment beliefs. Sustainable investing calls for a broader mission (examples of which are given in the full paper). With regards to beliefs, investors make judgements and decisions in the present, typically with reference to the past, to cope with or exploit an uncertain future by using their underlying beliefs about how the world works. The quality of those underlying beliefs is a major determinant of success in investment. Types and examples of sustainability beliefs are given in the full paper.

This paper outlines the importance of governance in adopting a longer-term outlook. Clark and Urwin identified 12 attributes of well-governed funds. Of these, mission clarity, a highly competent investment executive and a culture of learning are most critical in order to adapt to change. The authors discuss the use of feedback loops to adapt culture and investment strategies, the importance of stakeholder management during difficult times, as well as the importance of monitoring frameworks. Examples of attributes of a well governed fund are given in the full text.

Also outlined are the steps that could be taken by an institutional fund wishing to consider sustainable investing. Three key stages for an asset owner to follow are listed: 1) establish the strategic principles (mission, values & beliefs); 2) ensure appropriate enablers are available (governance & culture); 3) evolve investment policies (drivers, mandates & managers). For an asset owner, sustainable investing has implications for asset allocation, manager selection, mandate design (including benchmarks and fees) and monitoring of those mandates.

Appropriate strategic asset allocation is also discussed. It is stated that static asset allocation policies are unlikely to capture sustainability requirements, with a more dynamic approach required. Shifts in asset allocation are driven by longer-term anomalies rather than short-term price variations.

It is suggested that a long-term, integrated sustainability mandate would incorporate requirements for the underlying investment process to take ESG factors into consideration, as well as an assessment of the potential impact of externalities. They may also focus on specific themes (e.g. clean technology). Active ownership obligations would also be set out in terms of the policy regarding engagement. The International Corporate Governance Network (ICGN) has published a draft mandate which captures proposals for sustainable investment (outlined in the full text).

The authors argue that if asset owners adopt sustainable investing principles, it will affect their choice of asset managers to act on their behalf. ‘Sustainable managers’ will demonstrate a number of features in the way they run their business and in their investment philosophy and beliefs. For example, the potential impact of externalities will be anticipated and assessed and the responsibilities of ownership will be taken seriously through an appropriate voting and engagement policy. Sustainable managers do not compromise future performance for reasons of current business development. Features of sustainable asset management are listed in the full text.

In taking action, the authors state that industry change is likely to be significant in order to refocus on longer time horizons and, consequently, may take some time to implement. The authors summarise an action plan to help asset owners to progress (see full text).

In discussing the way forward a number of points are raised. There is significant growth in supply of investment options through expanded opportunities in environmental and energy technologies. Furthermore, there is greater application outside of quoted equity markets. Collaboration between governments, asset owners and corporations will be needed to achieve a sustainable investment future.

It is concluded that much of the investment industry is currently performance driven, with short-term behaviour leading to markets being prone to bubbles and crises. The authors believe that sustainable investing retains financial performance as its main driver, but that the outcome is beneficial to society.

The Kay Review of UK Equity Markets and Long-Term Decision Making Prof John Kay 01/07/2012
Measurement, Governance and Long-Term Investing WEF / Robert Greenhill and Michael Drexler 28/03/2012
Model contract terms between asset owners and their fund managers ICGN 01/03/2012
Sustainable Capitalism Generation Investment Management 15/02/2012
Capitalism At Risk: Rethinking the Role of Business Joseph L. Bower 03/10/2011
Promoting Longer Term Investment by Institutional Investors OECD 20/09/2011
Saving Capitalism from Short Termism Alfred Rappaport 01/09/2011
Current Corporate Social Responsibility Disclosure Efforts by National Governments and Stock Exchanges Initiative for Responsible Investment 01/08/2011
The Short Long Andy Haldane, Bank of England 01/05/2011
The Future of Long-Term Investing WEF / Oliver Wyman 24/03/2011
Capitalism for the Long-Term HBR 01/03/2011
Climate Change Scenarios – Implications for Strategic Asset Allocation Mercer / IFC / Carbon Trust 15/01/2011
Overcoming the Barriers to Long-term Thinking in Financial Markets Forum for the Future 12/01/2011
The Big Idea: Creating Shared Value Michael Porter and Mark Kramer, HBR 01/01/2011
Aspen Principles for Long-Term Value Creation: Guiding Principles for Corporations and Investors The Aspen Institute 01/06/2010
Investment Horizons: Do managers do what they say? IRRC / Mercer 01/02/2010
Marathon Club: Guidance Note for Long-Term Investing Marathon Club 01/04/2009
Who Cares Wins UN Global Compact 29/01/2009
Long-Term and Sustainable Pension Investments Dr Axel Hesse 01/05/2008
Corporate Citizenship and the Right to Vote: A Proposal Pr Yvan Allaire 01/11/2006
Breaking the short-term cycle CFA 01/01/2006
Integrating environmental, social and governance value drivers in asset management and financial research UN Global Compact 26/10/2005
Has Financial Development Made the World Riskier? Raghuram Rajan 01/09/2005

 

Document summaries written by Zoe Draisey, scholar, Forum for the Future.