Allocations to Sustainable Investing

Abstract

This paper presents a framework intended to provide pension funds and other institutional funds with practical guidance to their specific allocations to strategies in the fields of Responsible Investing (RI), Sustainable Investing (SI) and ESG (environmental, social and corporate governance factors in investment). While recognizing is growing footprint, RI/SI does not influence the investment of institutional capital that much yet. This is a normal trend-line in that whenever there is new investment thinking and practice it takes a while to become mainstream. The RI/SI industry though has the additional obstacle of confusing legal context to overcome. It follows that to establish their legitimate arguments, RI/SI strategies have to be taken beyond parity with traditional strategies and deliver a more compelling proposition both with respect to investment theory and the application of theory in practice.

In investment, critical thinking is captured in beliefs – conjectures and guides as to how the investment world works and how it can be exploited – those beliefs will be sourced from argument and measurement using critical tools of research and benchmarks. Developing strong and sharp beliefs is not that easy – it requires funds to deploy considerable governance. The beliefs that result from this process will generally cluster in three types: those that see stock-specific ESG factors as essential to risk control; those that identify ESG related assets that will benefit from tail-wind effects and nearly mover advantages; and those that adopt long time horizons and universal owner perspective in off-setting the longer-term risks and costs of natural resource depletion with ESG related investment. Such beliefs can then be aligned with two distinct approaches to sustainable investing: the integrated approach where ESG and active ownership are mainstream elements of the mandate; the targeted approach where specialist investment is concentrated in ESG related themes like clean tech and environmental opportunities.

Whatever the belief, the critical discipline is to employ a process for determining the suitable allocation to these sustainability strategies. Such a process starts with clarity of mission; works with a set of beliefs that have gained strong support from the fiduciary board; applies a quantitative discipline with respect to risk including the risk that departures from previous practice produce shorter term under-performance- The process is completed by overlaying a monitoring process that considers in parallel the returns and risks arising from both the financial and extra-financial missions; and ensuring that the beliefs and strategy are gradually adapted in the light of a fresh information that comes from monitoring process. For funds and asset managers that are signatories to the UN PRI code of responsible investing, the framework put forward has the merit of strengthening the audit trial to demonstrating adherence to the code.

Keywords: Pension Fund, Sovereign Wealth Fund, Sustainable Investing, Responsible Investing, Strategic Asset Allocation, Values, Beliefs and Norms, Governance, Fiduciary Duty