Market structure issues are compounded by consulting practices and processes.

Investment consultant beliefs

Investment consultants’ interpretation of fiduciary duties remains the single biggest barrier to progress. Our research suggests that the majority of investment consultants are sceptical that a focus on ESG issues can enhance investment performance. Many believe that a focus on ESG issues inevitably involves compromising investment performance. These views influence the advice that is provided to clients (e.g. on their investment beliefs on ESG issues) and the manner in which investment consultants conduct their research on asset allocation and on investment managers.

“We’re continuing to review the research both from academics and the industry. Our view is that ESG is a ‘do no harm’ at worse. We’re seeing our clients more open to considering an ESG mandate. However, it still feels like it’s early in the innings on evidence.”

“We don’t have a firm-wide view on climate change yet.”

The investment consultants interviewed for our research proposed the following reasons for these perceptions:

  • a lack of public commitments on ESG issues made by most consulting firms, or to applying these commitments across all of the advice that they offer – this limits the incentive for individual consultants to raise these issues with their asset owner clients;
  • a lack of robust academic evidence proving that a focus on ESG issues can lead to investment outperformance – this is compounded by the practical difficulties associated with assessing the influence of ESG issues and separating them out from quality factors in investment risks and returns;
  • many consultants continuing to equate responsible investment with negative screening;
  • very little, if anything at all being taught within the education syllabus and qualification processes for key professional exams in the sector (in particular, those for the CFA and for the professional actuarial bodies) about ESG issues – professionals may spend 3-10 years in training without understanding the importance of ESG issues and be unprepared to bring it to their clients;
  • a belief that if ESG issues are important, then investment managers should already be addressing them and that investment performance is the primary measure they should use to analyse how the investment manager is dealing with ESG issues;
  • consultants see ESG issues as being less relevant to passive managers, despite the proportion of assets that this sort of manager controls – this behaviour fits into an entrenched world-view of risk and return maximisation whereby a passive index (market-capweighted) represents the benchmark of optimal performance, and, crucially, where ESG represents a deviation from that benchmark. An interesting challenge to this is coming in the form of factor investing.

Factor investing

Factor investing points out that a number of methods of constructing portfolios on the basis of accounting or market data can outperform market-cap indices (either by improving returns or reducing risk).

A number of consultants expressed interest in approaches which combine factor investment with ESG data to create hybrid portfolios.

Factor investing is in its infancy, yet it does open up the possibility of seeing ESG issues as a factor to be incorporated on a quantitative basis into low-cost portfolios.

“There are currently no minimum expectations of field consultants on the extent to which they discuss ESG issues with their clients.”

“It’s much less risky to be late to ESG than early – unless you’re in California or you’re in a family plan or a small investment group where you can get everyone behind you. When you have a diverse constituent base there’s an ESG headwind. There’s lots of scrutiny across the industry, particularly if there is any hint of undermining returns.”

Service composition

Models that inform funding assumptions do not account for ESG issues (e.g. in the assumptions and scenarios that are being used to test portfolio resilience). While we did identify two interesting projects, we were unable to find any examples of where the incorporation of ESG issues into modelling had substantially altered asset allocation decisions. Responses showed that most consultants find it hard to understand the relevance of ESG issues to modelling in general. Most said that it would be a long time before ESG issues were incorporated in their modelling. Some felt that it would be undesirable. In most cases the funding discussion only treats investment allocations as broad “equity/bond” type measures. In these cases, the discussion would not set any further detail.

This raises two questions:

  1. Is it desirable for asset owners to receive ESG-aware funding or asset allocation advice?
  2. Can ESG make a difference to these areas?

Fundamentally these are strategic areas where risks are managed by the institution itself through funding rates or asset allocation. As noted above, there appears to be little development in this area. Work needs to be undertaken to explore whether existing models can be adapted, or if not, what additional tools or models need to be created in order for asset owners to receive ESG-aware funding or asset allocation advice.

Funding assumptions and modelling

Negotiations and decisions on funding are based around the funding risk. This is broken down by:

  • covenant risk;
  • liability risks (e.g. mortality, inflation);
  • asset-matching risk – primarily investment risks.

In most cases the funding discussion only treats investment allocations as broad “equity/bond” type measures.

Few consultants have considered the relevance of ESG issues to funding assumptions and investment models. Some examples of consultants who produce assumptions which include climate-change impacts were found, including “assumption-setting” models based on the impact of climate change on GDP (for example, we found one example of a 2 degree scenario costing 20 basis points over the base-case).

One firm we interviewed has tools to include the impact of climate change in their assumptions for valuations. However, these were the only two examples we found.

The client-consultant relationship

All consulting firms employ a “client comes first” approach. The process of discovering clients’ beliefs and interests is commercially led. Consultants may be reluctant to present ESG ideas to their clients if they do not believe that they generate revenue or they fear weakening their relationship with the client. Our interviews suggest that consulting firms do not make it a requirement of their field consultants to proactively raise ESG issues with clients.

Investment consultants see their role as advisory. While consultants can raise issues with their clients and make suggestions, ultimately it is for their clients to decide how they wish to act. There are also commercial dynamics at play; consultants (both individual consultants concerned about their career risk, and consulting firms as a whole) are reluctant to take actions that may jeopardise their relationship with their clients. This can include a reluctance to raise issues that are not of interest to their clients.

Incumbency can also make it hard to challenge beliefs. Consultants will spend time with new clients to understand their attitudes and views on a range of investment-related issues. They will often ask about ESG issues as part of this process. If the client’s initial response is that they are not interested or not aware, consultants rarely revisit this question. Indeed, consultants will research their clients in advance of providing advice. If a client has not made public commitments to ESG issues, consultants may interpret this as a lack of interest and therefore not raise ESG products, without directly asking the question.

DB DC risk transfer

The overall trend in global pension provision is of plans switching from DB to DC and entering into de-risking arrangements on their DB plans when their funding position allows.

Reducing the scale of plan deficits and risk transfer often dominates the agenda for scheme governing bodies and their advisers. Deficit discussions can also put strain on the relationship between plans and sponsors. While large unfunded pension liabilities can create a negative market perception of a corporate sponsor’s financial health, plugging large deficits will, in most cases, require significant value transfer by the sponsor. This will likely require the waiving of future dividends or taking on greater financial leverage.

The scale of such value transfer and the “notional” nature of deficit computation can make sponsors reluctant to consider ESG products, particularly given ESG products often attract higher fees.

“For a DB scheme, we determine the deficit, the covenant, and then determine the appropriate asset mix. For some closed DB pension schemes, close to buy out, advice is often to consider longevity swaps. For other funds, advice is to purchase LDIs to meet known liabilities. In both scenarios, we do not consider ESG.”

Firm structure

Different consulting firms have adopted different approaches to ESG issues. This includes the appointment of dedicated ESG staff, or “ESG champions” in the business, and/or the integration of ESG into product or service lines. We found little evidence to prove that the quality of ESGrelated advice is dependent on firm size or on how ESG advice is structured within the firm.

However, we did find that clients’ ability to access ESGrelated information and expertise is critically dependent on the individual consultants who manage the client relationship. The extent to which ESG issues are raised and discussed with clients is generally at the discretion of the relevant field consultant.

In practice, this means that these consultants see their role as being to respond to the issues and questions raised by the clients. The importance placed on client-led advice means that these consultants are reluctant to raise issues that are not requested by their clients. They tend to provide advice on ESG issues or access to ESG specialists only when this is specifically requested by the client. We were unable to find examples of consulting firms – other than as part of the general process of taking on new clients – requiring their consultants to raise ESG issues with clients. Interviewees for this research also commented that their organisational statements or commitments on ESG issues are generally perceived as secondary to the implicit or explicit preferences of their clients.

Fees

ESG-related research and advice is often seen as an additional cost to be charged to clients. This reinforces the perception that it is additional, and not integral to the core advice provided by investment consultants. It also creates a real barrier to asset owner clients requesting or accessing this research and advice. This applies across the whole range of fee models that we see in the investment industry. For example, in fixed fee contracts, asset owners may not include ESG issues in their requests for tenders as the inclusion of these issues may increase the fees that consultants seek to charge. If these issues are not included in the service agreement, there can be limited incentive for the consultant to raise them later. Similarly, in “retainer” or “pay-as-you-go” fee contracts, asset owners have limited incentive to raise ESG issues, as this may reduce the level of advice and support that can be provided on other issues.

This is a legitimate business issue. The development of ESG capabilities, research products, and the provision of ESGrelated advice, can involve additional costs. While larger clients have often received high quality advice and support from investment consultants, it is often seen as a bespoke service offering, not necessarily as something that can be replicated for more resource-constrained asset owners. One of the points that has emerged from our research is that there has been limited discussion of what a core (or universal) ESG service might look like. One area of progress has been the rating of investment funds. Some investment consultants are now providing some information on the ESG performance of these funds, either alongside more conventional investment ratings or integrated into the overall fund rating. However, the reality is that questions relating to ESG issues tend to be optional on due diligence questionnaires, and no consultants exclude asset managers based on their responses to these ESG questions.

Fund ratings

There are mixed approaches on how investment consultants provide ratings of funds managed by asset managers: a separate ESG rating alongside an alpha rating, or one integrated rating. The fund ratings of one firm we interviewed are comprehensive, with two ratings; an ‘ESG integration’ rating and a ‘stewardship’ rating.

However, in most cases ESG issues tend to be optional on due diligence questionnaires. Asset managers are “increasingly responding” to these questions, according to one interviewee. Most consultants understand ESG issues as separate from impact or screened investing. However, there are still consultants that consider ESG as ethical or non-financial. No consultants exclude asset managers based on responses to ESG-type questions. Few consultants ask about ESG stewardship.

Evidence shows that asset managers are becoming better at marketing their ESG capability. There is also some evidence that consultants are “getting better” at testing a fund’s approach to ESG issues. However, in terms of the broad approach taken to ESG advice, the overwhelming conclusion is that ESG issues are seen as a stock-specific issue picked up by investment managers. The perception is that ESG issues only affect manager research and reporting for the consultant.

“If the clients make ESG an integral part of the RFP process then we would factor that in the fee, because we know that it would include additional demands on our research team.”

Expertise and knowledge gaps

Investment consultants are a recognised source of investment expertise and to those clients that have been willing to pay for high quality advice on ESG issues, it has been delivered. However many interviewees commented that there are significant gaps in expertise and knowledge. In particular:

  • Investment consultants are struggling to carry out consistent quantitative research on investment manager performance on ESG issues. This lack of research reinforces perceptions about the lack of materiality of ESG issues to investment performance.
  • Investment consultants have limited experience of assessing or monitoring investment managers’ capabilities on ESG issues beyond listed equities.
  • Investment consultants tend to see ESG and responsible investment as primarily about whether and how these issues are taken into account at the level of the individual issuer (i.e. they are seen as being about stockpicking). Little attention has been paid to the relevance of these issues to asset allocation.
  • Asset allocation decisions tend to rely on backwardlooking data which may not capture the impacts of new and emerging risks such as climate change. In addition, asset allocation models tend not to explicitly analyse individual sectors, which is where it is most feasible to assess and model the implications of ESG issues.

Potential solutions

  1. Incorporate ESG in asset owner investment strategies and investment consultant beliefs
  2. Reframe the objectives, philosophy and composition of service lines
  3. Enable asset owners to explicitly account for ESG capabilities when appointing and reappointing investment consultants
  4. Publish minimum requirements on ESG
  5. Develop expertise on ESG issues
  6. Integrate ESG in the client-consultant relationship
  7. Develop guidance on fiduciary management

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