Sustainable investing: A first step
5 October 2023
Welcome to the first instalment of Compound Interests - Mercer’s perspective on the capital markets, asset management, and how you can get the most out of your investment portfolios.
In this first installment, we consider Environmental, Social and Governance (ESG) factors - how investors are thinking about them, what investors’ and asset managers’ future plans are with respect to ESG, and how ESG fits into our present, low-growth, high-interest rate environment.
A first step
In our 2023 “Reshaping the Future” survey of Defined Benefit (DB) plan sponsors, we found that all plans, regardless of their size, are facing the same drivers and motivations to incorporate ESG factors.
In fact, incorporating ESG ranked as the second-highest investment management priority for DB plan sponsors, and 70% of respondents said that they viewed integrating ESG factors as important to their investment decisions.
The top three reasons to integrate ESG factors? To align an organization’s investment practices with its corporate mission or beliefs, to follow the ESG investment beliefs and policies of the plan, and to respond to stakeholder demands and feedback.
That said, our survey also said that the top DB plan priority this year is de-risking the plan: understandable, when low economic growth and recession fears dominate the landscape.
Defined Contribution (DC) plan sponsors, for their part, are just thinking about taking the first step.
How, then, should plan sponsors - Defined Benefit or Defined Contribution - view ESG?
Every plan is at a different point in its ESG journey. But every journey starts with a single step:
- Step one: Review your governance framework – Plan administrators are ultimately tasked with the responsibility of identifying material risks faced by the plan, and prioritizing accordingly. They need to have the appropriate governance, risk management and decision-making practices to identify and respond to risks that are important, relevant, and material to their plan. What are your organization’s beliefs around ESG factors, and how they factor into return?
In 2023, as de-risking is top-of-mind for all plan sponsors, this is of particular note. Will incorporating ESG factors into your investment approach reduce long-term climate risk?
If you have already established your organization’s ESG beliefs, now is the time to reflect on your own governance processes. Canvass perspectives and document them, modernize your governance documents and policies - so that when you make a change to your investment approach, the process is unassailable.
- Step two: Assess your portfolio - If you have established your perspective on ESG and thoroughly examined your plan’s governance, now is the time to assess your exposure to key ESG risks - and plot a way forward. In a 2020 whitepaper, Shifting to Green, we charted the path forward for decarbonization. A similar approach can be taken for Social and Governance risks.
- Step three: Design your roadmap - Stayed informed and educated about new developments, have a plan for reviewing periodically and being able to identify when there have been significant changes in risk and opportunities. Engage with external managers and consider a transition plan if that’s determined to be relevant for your plan.
Every organization is at a different point in their ESG journey. But every journey starts with a single step. Contact your Mercer consultant to discuss how your organization can plot a way forward on ESG.
Today’s capital markets
As summer turns to fall, we look back and consider how the year has unfolded so far.
It’s hard to believe that only six months ago, we were gravely concerned about the health of the banking system, the failure of Silicon Valley Bank and the forced takeover of Credit Suisse by UBS weighing on financial conditions. A year ago, many of us were expecting severe economic pain as inflation hit 40-year highs, the UK was in a self-inflicted crisis of confidence, and the conflict in Ukraine foretold of a winter of energy shortages in Europe.
Things for now have turned out quite a bit better than feared. Markets have generally been kind, so far, with world equity indices registering double-digit gains. Bonds indices are however in negative territory year-to-date at time of writing. Many of our clients now find themselves in a healthy financial position. It would be tempting to say that the storm has passed, but that may be premature. Year-over-year Inflation has fallen, as was expected, but still remains stubbornly above 2%. The trajectory of interest rates also remains uncertain, though it appears likely that we are closer to the end of this hiking cycle. How much damage will be caused to the economy and to overstretched households before all is done remains to be seen. Put another way, there are many “stress” scenarios we can pace our portfolios through, across a range of variables that require a more nuanced approach to risk than wagering whether there will be a “recession” or not.
Continued uncertainty in markets however continues to make a strong case for maintaining a diversified investment strategy. We continue to advise clients that investments across equity, fixed income, credit, real asset, and absolute return strategies play important roles in long-term, resilient portfolios. Monitoring high valuations and increased concentration in large (think internet and technology) positions in the US market also puts the highlight on the potential contribution of active management in an environment where passive options are not without their share of risks.
Other attractive opportunities are also on the radar. In the credit sectors, many higher-yielding strategies now have the potential to deliver attractive returns, while enhancing diversification across both public and private assets. Opportunities can also be considered within alternative asset classes as the potential for traditional “60/40” equity and bond portfolios to deliver above long-term average returns again over the next decade can be questioned.
In Canada, the economy looks like it will have grown at a moderate pace so far in 2023, but the global economy is gradually cooling, and we cannot isolate ourselves from reality. An uptick in inflation is still very much in play with survey data and gasoline prices pointing to a rebound in inflation in the coming months. We will be closely watching our dashboards in the coming weeks and months.
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