Corporate governance and the environmental and social performance of companies (collectively known as 'responsible investment' are emerging as some of the key issues of today for the investment industry. Responsible investment capability is increasingly becoming a strategic competitive imperative for the European fund management industry as it seeks to win global institutional mandates. Factors fuelling this trend include the threat of increased legislation, the increased emphasis on shareholder activism, and recognition by the fund management community of the importance of engagement in the management of risk.
This pattern is particularly apparent in Europe, where many in the investment community are looking at how best to position themselves to address and capitalise on these issues.
A number of engagement and responsible investment approaches have been developed by fund managers. However, recent research by CRG Advisory Services in the UK has shown little consistency of view as to what responsible ownership means to investors, and no consistent approach to implementation of engagement and responsible investment processes and activities by fund managers.
This article explores some of the reasons for these findings, and examines how this area of the industry may develop in the future.
The regulatory environment
In March 2000, Gordon Brown, the UK Chancellor of the Exchequer, commissioned Paul Myners to conduct a review of institutional investment in the UK market. The review was asked to consider whether there were distortions in institutions' investment decision-making. The efficiency of investment decision-making is an important driver of productivity, helping to ensure that capital is allocated effectively and that fund managers are monitored and held accountable for performance.
One of Myners' main conclusions was that many pension fund trustees lack the necessary investment expertise to act as strong and discerning customers of the investment consultants and fund managers who sell them services. He stated that resulting problems include:
- poor evaluation of advisers and their advice;
- a reliance by trustees on a small number of investment consultants, who supply actuarial and investment advice bundled together;
- insufficient resources devoted to the process of asset allocation, relative toits impact on total fund returns;
- unclear contractual structures which generate strong and unnecessary incentives for herding and short-termism in investment; and
- insufficient focus on the potential for adding value through active shareholder engagement.
Subsequently, the UK Treasury has published a number of pieces of work on issues surrounding shareholder activism. The most recent update to 'The Myners Review', issued in December 2004, emphasised that the Government remained committed to legislation if there was insufficient evidence of effective activism by institutional shareholders and fund managers acting on their behalf. A further report is anticipated in 2006.
In response to this threat of legislation, the Institutional Shareholders Committee (ISC which comprises the National Association of Pension Funds, Association of British Insurers, Investment Management Association and the Association of Investment Trust Companies) published a Statement of Principles on the Responsibilities of Institutional Shareholders and Agents1 in October 2002. This statement was aimed at furthering the application of best practice to the relationship between institutional investors and the companies in which they invest with the objective of securing value for beneficiaries over the long term.
The Principles were revised in September 2005 to include a clear signal regarding the role of engagement in the investment management process. This was in response to the view that there is significant 'importance now attached by institutional investors to developing a high quality all-round relationship with the companies in which they invest'.
A similar provision regarding engagement and the transparency of the voting and engagement process has been introduced into Dutch law when the Corporate Governance Committee chaired by Morris Tabaksblat published its work, the 'Principles of good corporate governance and best practice provisions' in December 2003. This formed the basis of the Dutch Corporate Governance Code which came into effect in 2004.
The Code has several best practice provisions regarding the engagement responsibilities of institutional investors.
The investor response
The introduction of the UK Pensions Act 2000 by the then Treasury minister Stephen Timms required pension funds to disclose whether they take social, environmental and governance issues into account in their investment process. This 'light touch' regulation was designed to stimulate a cultural change in the industry. The reaction from the majority of pension funds in the UK was to delegate the execution of this process to their agents, the fund managers, via their contractual arrangements.
There are mixed views as to whether this has been a success or not. However, recently published research on the views of 79 pension fund trustees by the UK Social Investment Forum2 has shown that the adoption of responsible investment practices is increasing, albeit slower than some might have predicted. One interesting response from trustees was that they felt more regulation was required in this area as opposed to the ISC and Government's view that there should be less.
In the European context the European Community has initiated a number of studies and published consultative documents on various aspects of corporate governance, shareholder engagement and socially responsible investment. A number of the largest Dutch pension funds, including ABP and PGGM, already have well established engagement programmes. In France the visibility of socially responsible investment has been increased by recent government initiatives on corporate disclosure, as well as the estimated EUR600m mandate to be introduced by the French Federal Reserve pension fund in 2006.
Elsewhere in the world shareholder activism, corporate governance and socially responsible investments remain contentious topics. Some progress has been made in the US where retail SRI funds are well established, but efforts by institutional pension funds such as CalPERS to promote shareholder activism have led to strong lobbying on behalf of public companies to limit shareholder rights. In Asia, there has been substantial progress in countries such as Australia, Japan and Singapore to strengthen responsible investment activities.
Concurrent with legislative changes, the global fund management community has also been re-examining its attitude to risk, particularly in the wake of financial scandals such as Enron, Parmalat and so on. In the UK and other European markets there is now an increasing number of fund managers who recognise that shareholder activism and engagement represent a real opportunity to reduce the level of investment risk and to uncover potential investment opportunities.
The principle that an active investor is a more informed investor is gaining increasing support in the global institutional investment community.
Responsible investment tools
Research and engagement
The most 'active' activists in the fund management industry tend to have some socially responsible investment (SRI) interests. However, the trend is moving from an SRI 'values' agenda towards one of opportunities and risks. Evidence of this can be found in the increasing number of research reports from global investment banks such as Goldman Sachs, Morgan Stanley, Citigroup and UBS regarding environmental, social and corporate governance issues, opportunities and risks. This change has been driven by one thing and one thing only - investor interest - as without this, investment banks would not invest in setting up and supporting responsible investment research teams.
The way investors go about becoming more 'informed' about a company's corporate responsibility and governance performance tends either to be by utilising one of the commercial data and rating agencies, such as EIRIS or Innovest, and incorporating this information within their in-house research and engagement processes, or by simply outsourcing this whole activity to a third party.
Engagement with the management of companies can take many forms ranging from a simple written request or questionnaire to structured meetings with company executives and investor relations managers.
Effective investor engagement requires informed consideration and judgment, and cannot be achieved by a 'box ticking' approach based only upon completion of a research questionnaire. As will be discussed later, the amount and level of resources as well as the influence that the information gathered has on the investment view of a company varies greatly between fund managers.
Some fund managers see engagement as key to the creation and protection of shareholder value; others go through the motions of engagement to enable them to exhibit, in pitching for pension fund mandates, a basic level of competency in this area. Others use engagement for little more than an indicator as to which way to vote their clients' proxies.
What is clear is that fund managers are continuing to develop their expertise and resource in this area in line with increasing client interest and the shadow of unwelcome legislative intervention.
The FTSE4Good indices
In July 2001 FTSE Group (FTSE), the global index company, created the FTSE4Good Index in response to the increasing attention being paid to responsible investment from a broad range of investors. Also, an increasing number of FTSE's institutional clients were looking for customised benchmarks, which reflected particular concerns relating to a range of extra-financial factors. Since its launch, the FTSE4Good Index has become one of the most influential responsible investment indices in promoting a greater attention to and disclosure of corporate responsibility policies and management systems in some of the best known companies worldwide.
FTSE4Good Index Series: Key objectives and features
- Key objectives
- To provide a tool for responsible investors to identify and invest in companies that meet globally recognised corporate responsibility standards. These companies are best positioned to capitalise on the benefits of superior non-financial risk management, and the opportunities brought by good corporate responsibility.
- To provide asset managers with a basis for responsible investment products (such as tracker funds and structured products), as well as a benchmark for all socially responsible investment products
- To contribute to the development of responsible business practice around the world.
- Key features
- Evolving selection criteria to reflect changes in globally accepted corporate responsibility standards and codes of conduct over time
- Criteria are challenging yet achievable to encourage companies to strive to meet them
- Higher impact companies have to meet higher standards
- Transparent criteria and methodology
- Criteria based on respected codes and principles
- New criteria drawn up by experts following widespread consultation and approved by an independent committee made up of experts within the field of corporate responsibility, governance and responsible investment
To be eligible for inclusion, a company must meet transparent public corporate responsibility criteria in three broad areas:
- Human rights,
- Environmental sustainability, and;
- Social and stakeholder issues, including supply chain labour standards and anti bribery.
These criteria are designed to reflect a broad global consensus on what constitutes good corporate responsibility practice.
The objectives of the criteria are that they should be challenging but achievable. In addition, the requirements for companies are continually evolving. Companies therefore have to continually respond and meet the increasing entry level to maintain their index membership. FTSE4Good is unique in the responsible investment area due to this embedded constant improvement requirement it sets its member companies. The other unique feature is that this also enables FTSE to measure the impact the index is having on contributing to improvements in standards of corporate responsibility behaviour and performance from companies globally.
The FTSE4Good Indices are used by investors in a number of different ways including:
Index tracking funds
Companies in the index are bought in the same weighting as the index and should therefore closely track the performance of the index. They tend to be very low cost for investors.
Active or enhanced index funds
This type of product is where specific bets are taken to over- or under-weight specific companies or sectors within the index. Companies are only those that are included in the Findex. These products have a higher tracking error to the underlying index, but a higher rate of return than that delivered by the index is expected for this type of strategy.
Structured products
Structured products have been a very popular type of investment, particularly in the retail sector, over the last 10 years. The majority of business linked to the indices is currently to be found in a range of structured products. These products work by capturing the upside performance of the index with a 'guarantee' of the capital invested returned at the end of the term. Most FTSE4Good products provide for on average a 90% of the index upside performance as part of the investment's attraction. The average tranche size of this type of products is currently between GBP10m and GBP15m. A number of investment banks operate in this sector providing the swap or hedge to the product's issuer to capture the index performance.
Active investment universe
A number of investors are also using the index's company membership as evidence that companies not in or dropped from the index are clearly not addressing their non-financial risks and opportunities in a structured appropriate manner. These companies subsequently become targets for specific attention by investors and the media who want to understand why this is.
Increasing influence of the FTSE4Good indices
Codes of practice and increasingly may provide a starting point for companies to improve their social responsibility. However, indices that are well designed, constructed and widely followed can provide the framework and encouragement for companies to adopt good practice that law makers and regulators cannot.
Unlike asset management companies, index companies producing SRI indices do not enjoy the leverage of ownership to direct corporate behaviour. However, through the FTSE4Good index, FTSE is making a significant contribution to raising the standards of corporate responsibility on behalf of investors and FTSE's global clients.
Since the creation of the index in 2001, increasing numbers of companies are meeting the challenge posed by the expectations of a wide range of global investors and expressed in the FTSE4Good index criteria. Many NGOs, investors and other followers of corporate social responsibility are continually seeking answers to the question of how companies are responding to the demands of society. One indicator that can help is the future programme of development and tightening of the FTSE4Good index criteria, as this creates a compelling challenge that most companies currently in the index appear willing to meet.
From an investment perspective, FTSE4Good therefore provides investors with exposure to a broad range of companies that are doing more to manage their environmental and social impacts, and capitalise on benefits of good corporate responsibility practice. Through investing in FTSE4Good companies, investors enjoy the additional security of avoiding companies who are laggards in corporate responsibility as these companies are the most at risk from potential environmental and social disasters. The FTSE engagement programme and the criteria development programme provide FTSE4Good investors with the mechanism to contribute to the encouragement of responsible and sustainable business practice around the world.
How are fund managers likely to develop their responsible investment approaches?
Across the world attitudes to corporate governance, corporate responsibility, shareholder engagement and activism vary greatly. However, there is a general trend towards global investors seeking increasing levels of transparency and accountability from companies that they are invested in.
In this context, definitions of what activism and engagement actually mean vary greatly. For some it is a measure of aggressive shareholder intervention; for others engagement simply means voting on shareholder resolutions. In the UK, for example, a market niche is being established by a small number of players including F&C, Insight, Governance4Owners and Hermes, which focus on providing engagement expertise to pension funds and other institutional investors. Evidence suggests the market for these services is likely to grow in future.
Engagement with the management of companies is often viewed as a continuum of activity, ranging at one end from initial requests for information, through a process of dialogue, ending, in those cases where this dialogue has resulted in an unsatisfactory outcome, to a process of direct intervention in the company.
The measurement of engagement outcomes and the value that can be ascribed to it is an area of continuing debate in the investment industry. There are however some managers that can show engagement cause and effect and the value, in financial terms, created for shareholders. In this area of measurement, further research and standardisation is required.
Effective investor engagement requires informed consideration and judgment and investment managers and asset owners apply a range of approaches to engagement, using different methodologies and strategies, which work, arguably, with varying degrees of effectiveness. In addition, the amount and level of resources, as well as the influence that the information gathered has on the investment view of a company varies greatly between fund managers.
Fund manager engagement models and approaches
Research conducted by CRG Advisory Services has identified at least five approaches to company engagement adopted by fund managers in the UK. Some of these approaches are also being increasingly used by fund managers across continental Europe.
Broadly, the models of approach can be segmented and identified by the importance of engagement and the likelihood of that engagement influencing the broad mainstream investment decision-making process.
Briefly, the key characteristics of each can be described as follows.
'Progressive' engagers typically have a retail orientation and manage retail and institutional SRI (ethical) funds. These managers directly employ small teams of people who focus on SRI, corporate governance and engagement issues. They regard their competence in this area as an increasing point of competitive differentiation.
Progressive engagers believe engagement on social, ethical and environmental issues to be a core activity and are driving this into their mainstream analytical processes. However, in many cases, corporate governance is managed discretely.
'Active' engagers also have a retail orientation and manage retail ethical funds. The key difference in this model is that these managers have commercialised their engagement services expertise - which they now market to pension funds and other non asset management clients.
'Governance' engagers may have a mixed retail and institutional focus, with a small scale engagement program sufficient only to provide evidence of an 'adequate' level of competence to their clients and potential clients. A programme may focus on the employment of one or two engagement specialists or the use of a specialist third party provider.
Governance engagers typically work with companies only on key strategic or financial issues, sometimes acting collaboratively or through trade bodies, particularly in relation to corporate governance issues.
An 'Alpha/analytical' engager is a fund manager, with an institutional focus, which sees engagement as a route to superior performance and value creation. Essentially 'alpha' (or performance in financial return) is the key objective for engagement. This type of organisation has established a large engagement team, including analysts, lawyers and industry specialists, which it deploys only when it believes engagement can deliver superior investment returns. Typically, engagement is limited in terms of the number of target companies.
Free riders are fund managers who have made no investment in engagement activities beyond voting on annual or special resolutions. Indeed the manager's only contact with invested companies is through voting, typically using third party voting recommendation services. These organisations do not normally get involved in trade association-led initiatives or the sorts of collaborative engagement activities undertaken by governance engagers. Many small and mid-sized UK fund managers follow this approach.
A common feature of the models used by managers was that a majority had no clear strategy for how to develop and leverage this activity and expertise within their organisations. Although most respondents could identify where they were, few had a high level of market intelligence as to how other competing managers were addressing the same issues.
As signals from institutional investors become clearer and stronger, these are questions that asset managers will have to address as part of their strategic business planning processes.
One strategic direction that managers could deploy is depicted in the diagram below. It envisages that fund managers will develop resource and capability to integrate fully into their investment process a system to capture and utilise the deeper understanding and knowledge of companies that well executed active ownership strategies creates. This should enable a clear cost benefit model to be developed and enable managers to meet the requirements of more demanding institutional clients who are subject to direct regulatory influence and pressure, particularly public pension plans in the major European markets. These are in effect the industry's 'progressive' managers.
Conclusions
It is clear that asset owners in many developed markets will continue to be pushed by regulatory influence to integrate responsible investment practices into their investment process. Responsible investment practice will become an increasing competitive differentiator for asset managers competing for institutional mandates from the largest global investors.
An increasing number of tools to evaluate performance will develop to support this growth, and leading companies will see good corporate responsibility as a means to add to shareholder value and therefore focus on structured investor communication programs to promote that message.
There are, undoubtedly, exciting and challenging times for the development of these disciplines within the global investment industry lying ahead.
References
1 www.napf.co.uk/publications/Downloads/PolicyPapers/sectionI/2005/Comment_on_ISC_Principles.pdf.
2 Just Pensions Report February 2006 - Are UK Pension Funds Responsible? www.uksif.org.
