This is an exciting time for Mercer. Since 2008, our manager research team has been evaluating investment managers based on integration of environmental, social and governance (ESG) issues, allowing our clients to make more informed decisions in the selection and monitoring of managers. We have now reached the milestone of 5,000 ratings assigned to strategies across geographies and asset classes. The following article takes stock of our ESG ratings and ESG integration among institutional managers: where we’ve been and where we’re going.

As of the publishing date of this article, Mercer is the only consultant that assigns ESG ratings across all asset classes as part of its manager research process, providing a consistent and thorough way to evaluate how managers approach ESG and stewardship. ESG ratings are applied by the Mercer researcher reviewing a strategy. The ESG rating sits alongside the traditional alpha rating (A, B+, etc.) and will be considered by the researcher along with other relevant factors. Maintaining parallel ratings instills a disciplined process to embed ESG questions as part of Mercer’s core research process, and provides a unique ESG marker for the growing number of clients that want an independent assessment of how well current or prospective managers are integrating ESG analysis and stewardship practices into core processes. 
 
As the pool of ESG rated strategies has expanded to over 5,000 strategies¹, momentum continues to build and clients continue to find new ways to utilize the ratings as part of their investment decision making and monitoring processes.

Mercer will continue to pursue these issues with fund managers as asset owners increasingly consider ESG factors in their performance review and selection criteria of fund managers.

ESG ratings highlight potential for improvement

When assigning our ratings we categorize managers into four groups – ESG1 (the highest rating) to ESG4 (the lowest rating). For a strategy to be assigned an ESG1 rating, the investment team must have demonstrated market-leading capabilities in integrating ESG factors and active ownership in some or all of the following processes:

• Generation of investment ideas
  

   

• Construction of portfolios
  

   

• Implementation of active ownership practices (through voting and engagement)
  

   

• Demonstration of the degree of firm-wide commitment to ESG issues

At the bottom end of the scale, an ESG4 rated manager is considered to be lagging across all of these issues with little indication of intention to improve practices in either ESG integration or active ownership practices.

Within the current pool, 9% of strategies receive the highest ratings of ESG1 and ESG2. This has remained fairly consistent since Mercer has analyzed these results and as the pool has grown. Clearly, we could apply softer standards and award a larger number of ESG1 and ESG2 ratings. However, our intention is to distinguish the groups which are, in our opinion, leading the way in ESG integration. Our findings suggest that the industry as a whole has considerable room for improvement, though there continues to be innovation and curiosity from managers across asset classes and regions.

Global coverage of all asset classes expands

Our research is global and covers all asset classes. Of the 5,175 strategies with assigned ESG ratings, around 57% are in listed equities, 20% fixed income and the remaining 23% across alternatives. As demonstrated in Chart 1 below, private equity has the highest proportion of high ESG rated strategies, partly due to expanding coverage of renewable energy and cleantech funds within this asset class. Property and infrastructure have the next highest proportion of highly rated ESG ratings, although there are no ESG1 rated infrastructure strategies. Hedge funds and fixed income have proven the most difficult for managers to integrate ESG issues. This is due to a number of factors including lagging research on the ESG characteristics of sovereign debt and private companies and a lack of consensus on how ESG factors should be applied to some hedge fund strategies, particularly those that are high turnover, trading-based strategies. With regard to both hedge funds and fixed income, we note that ESG research provided by third parties is becoming more applicable and Mercer sees more products coming to market with ESG characteristics embedded. More detail on the breakdown of ratings by asset class is provided in the chart below.

Chart 1

Chart 2 illustrates the breakdown of ESG ratings for each region². Note, the region signifies the focus of the strategy, rather than the local of the manager (for example, an emerging markets mandate could be managed out of the UK, Singapore or elsewhere). Emerging Markets and Asia-Pacific have the highest proportion of ESG1 and ESG2 strategies of all the regions covered³. We find this interesting as it appears to speak to greater demand for broad sustainability considerations in emerging markets, perhaps given population growth and demands on resources. In speaking with managers, we have also observed that the lack of consistent and comparable data in some of these markets makes reliance on company governance and reputation, both linked to ESG, more important for investors. Conversely, and Canadian strategies demonstrate the lowest ESG ratings.

Chart 2

Do PRI signatories and sustainability themed funds grab top marks?

As one might expect, 58% of the ESG1 rated strategies are “ESG” or “Sustainability” branded or thematic strategies, and 72% are managed by signatories to the United Nations Principles for Responsible Investment (UN PRI). Of the ESG2 rated strategies, a smaller percentage of strategies – 22% – represent ESG or sustainability-branded. This means the other 78% are “mainstream” strategies which incorporate ESG into their analysis to make well-informed buy/sell decisions. PRI signatories manage 68% of the ESG2 rated strategies.

Learning by example: what are the leaders doing?

Mercer’s approach to evaluating ESG integration into core investment processes is not to encourage ‘box ticking’ or prescribe a ‘one size fits all’ model. Rather, we look for an indication that managers have made an effort to integrate ESG factors into their alpha generation process as well as beta enhancement through exercising their ownership rights. 466 strategies (9% of the total pool) have been assigned the highest ratings of ESG1 or ESG2, across regions and asset classes (as the preceding charts indicate).

Whilst practices vary, managers often have the following common features:

• A demonstration that ESG factors feature in investment teams’ decision making process and corporate culture
  

   

• An effort made to build in some ESG factors into valuation metrics, using their own judgment about materiality and time frames
  

   

• A long-term investment horizon and low portfolio turnover
  

   

• Ownership policies and practices that include sufficient oversight, integration with investment decision-making and transparency
  

   

• For alternative assets, evidence of pursuing best practices in transparency and evaluation, monitoring and improvement of ESG performance as relevant for portfolio companies and sectors
  

   

• A demonstrated willingness to collaborate with other institutional investors to improve company, sector or market performance
  

   

• A commitment to ESG integration at the organization-wide level

Managers, asset owners (and consultants) can all expedite progress

Our research to date suggests that there are pockets of good practice and innovative approaches emerging amongst fund managers in terms of ESG integration and active ownership. However, fund managers can still greatly improve how they communicate their ESG integration practices to investors. On the other side of the coin, asset owners can take steps to better communicate their interest in ESG integration to fund managers and consultants, as follows:

• Clarify expectations by revisiting investment policies and beliefs
  

   

• Formalize ESG and active ownership expectations into requests for proposals and investment manager agreements

   

• Build ESG and active ownership expectations and metrics into the way consultant and fund manager performance is measured and reviewed
  

These steps are also being encouraged by groups such as the International Corporate Governance Network (ICGN) and mainstream industry bodies such as the UK’s National Association of Pension Funds (NAPF). For example, in its 2009 guidance on responsible investing, the NAPF recommended that pension funds consider reviewing their responsible investment policies and “incorporate an assessment of [them] into their manager selection process and, with their advisers, develop tools for monitoring how managers apply that policy and how they hold companies to account on behalf of the pension scheme.”⁴ Additionally, the ICGN’s Model Mandate initiative provides “guidance on areas about which clients may wish to enter into active dialogue with existing and potential fund managers to ensure that their interests are aligned…”,⁵ with the end goal of helping asset owners to more fully consider their expectations of fund managers. In addition, academic evidence has generally supported the integration of ESG issues into portfolio management,⁶ with a growing number of studies now supporting this thesis across asset classes⁷.

For asset owners that seek to behave as long-term responsible investors, this is an opportune time to mobilize your power and progress the industry to the next level.

Ask your consultant about ESG ratings today.

Footnotes