Responsible Investing: The Promise and Perils of Customized Portfolios

Should Investment Counsellors and Multi-Family Offices invest the time and effort required to create bespoke Responsible Investing (RI) or Environmental, Social, and Governance (ESG) portfolios for clients, or is there a better solution? In this article, Mark Webster, Director, Institutional & Advisory ETF Distribution, traces the origins and evolution of RI, outlines the potential pitfalls for discretionary managers, and discusses the methodology behind BMO’s suite of ESG index ETFs.

Not a week goes by without some press coverage discussing aspects in the Responsible Investing (RI) or Environmental, Social, and Governance (ESG) landscape. Part of this may be attributable to a U.S. election year, where a stark divide between the two leading political parties provides a great topic to accent their divisions. Digging deeper into the reservations surrounding so-called ​‘green’ endeavours or initiatives, it is clear misinterpretations or misunderstandings are responsible for some of the rhetoric.

Understanding ESG

Responsible investing started in the 1920s, when religious groups in the United States expressed their desire to invest their capital with companies that shared their principles. The notion was that investors could allocate their money to companies whose principles and practices met or conformed with specific values. Shortly thereafter, when the U.S. was struggling through the Great Depression, people developed the concept that companies should be good corporate citizens, measured on the basis of their operation’s impact on society as a whole. Both these phases spawned what came to be referred to as Socially Responsible Investing.

It was much later, during the 1960s and the ecology movement, that care for the environment rose to prominence. Air and water pollution and, to a lesser extent, land erosion had become important considerations, surpassing social concerns which had formerly dominated discussions.

Gradually, green parties formed in most Western countries, promoting a largely, though not exclusively, environmental agenda, and this has played a prominent role in promoting green investing. Some expressed green investing by excluding something undesirable while others preferred overweighting desirable criteria. As the movement grew, so did the number of expressions, something with which we continue to grapple.

In the new millennium’s early years, the United Nations (UN) recognized ESG as a distinct fiduciary obligation because ESG’s stated objective was to identify business practices which could reasonably be expected to impair capital, and thus pose fiduciary risks. As a fiduciary risk management measure, ESG sits on a different plane from other RI or Sustainable interpretations or definitions, largely because fiduciary obligation has a foundation in common law.¹

Financial reports had always disclosed contingent liabilities, albeit often in footnotes, but ESG drew these considerations into the security selection process. As a fiduciary risk management concept or principle, ESG cannot be ignored in discretionary asset management.

Implications for Investment Counsellors and Multi-Family Offices

Regardless of definition — be it Responsible Investing, Sustainability, or ESG — the data set at hand is enormous. Some counselling firms have decided to become U.N. Principles for Responsible Investing (PRI) signatories to demonstrate their bona fides to their clients but, unless the firm has tremendous resources, maintaining their UN PRI signatory status is likely to impose a significant reporting burden. Should they be poorly rated, there may also be significant reputational risk.

Large pension plans in Canada have created internal capabilities to manage ESG but smaller plans have delegated responsibilities in this realm to their asset managers. Given that most small pensions are significantly larger than Investment Counsellors, it might be a good idea to heed this example.

The Problem and the Solution

Multi-Family Offices and Investment Counsellors often try to customize portfolios to meet individual client objectives, demonstrating the value of high-touch service. This is difficult as a firm adds additional clients; it is unquestionably possible in equities, less so in fixed income, and highly debatable in RI/ESG.

Clients investing through discretionary managers must have an investment policy statement (IPS), which defines the objectives to govern the way assets will be managed. As the McCarthy Tetrault article cited in footnote 1 discusses, no alterations are required when ESG is incorporated into the security selection process because ESG is a fiduciary obligation.

If, however, exclusionary or overweighting strategies are implemented, each IPS must be amended to account for constraints which may hinder the ability to meet required rates of return.

Education on this topic is vital to steer clients to the middle of the road, towards the ESG fiduciary obligation and away from exclusionary or overweighting approaches. Not only is this more scalable from an asset allocation model perspective, it also lessens compliance and operational burdens.

The MSCI ESG Leaders Approach

As an asset manager, we, like the largest pension plans in the world, are a universal owner, meaning that we own a portion of the entire market or economy. As such, we performed extensive due diligence before deciding on an approach to provide to our clients. We had to answer a fundamental question when deciding how to define our solution: What were we trying to solve and for whom?

Individuals may choose to tilt their exposure to reflect whatever values or outcomes they deem appropriate, but institutions — be they pensions, endowments, or discretionary investment counsellors — are governed by their fiduciary duty and therefore must tread very carefully. 

Recognizing the legal necessity fiduciaries have to maintain their responsibilities, we selected the MSCI ESG Leaders indices for our ESG listings. Not only is MSCI among the largest RI/ESG data providers in the world, they also have broad respect as an institutional benchmark provider. Combining both the rigorous measurement, ranking and monitoring with respected indexing capabilities strengthens the investment thesis underlying the methodology.

First and foremost, being an index, the methodology is explicit and consistent, ensuring uniformity across regions and asset classes. In addition, there are specific exclusions on controversial business practices, not on industries or sectors. The objective in identifying specific exclusions is to uphold the fiduciary risk management concept which underpins the ESG approach:

Conclusion

There is greater regulatory scrutiny on RI, Sustainability, and ESG everywhere. Due to Canada’s numerous regulatory bodies, there continues to be debate on how they should be governed. Investment Counsellors and Multi-Family Offices should take great care when implementing these types of strategies for their clients, being mindful of the compliance and operational strain customization could pose. Educating clients about fiduciary constraints, yet providing a thorough and measurable solution through inexpensive and scalable ESG ETFs will provide counselling firms with a coherent foundation to meet their client requirements while maintaining their fiduciary duty.

For those interested, the BMO ETF ESG Report Card provides comprehensive reporting on the exposure and on the stewardship reinforcing the holdings.

To learn more about BMO’s suite of ESG ETFs or receive other trading insights, reach out to your BMO ETF Specialist at their email address or via telephone at 1−877−741−7263.

¹ Randy Brauslaugh and Dr. Hendrik Garz, ​“Pension Fund Investment: Managing Environmental, Social and Governance (ESG) Factor Integration,” McCarthy Tetreault, May 1, 2019.