Sustainable Fund and Manager Due Diligence

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Introduction
The growing traction of sustainable investing and sustainable investment funds[i] has brought with it increased attention to how these products are managed.  For fiduciaries, institutions and financial intermediaries as well as, robo-advisors and other platform “gatekeepers,” this has introduced a range of new due diligence questions.  These questions address what should be considered when evaluating and overseeing sustainable investment fund managers. 

Not surprising, there is no single answer to these questions.  In this paper, we provide what we believe, are some primary considerations for conducting sustainable manager and fund due diligence.  These are discussed below.

Recognizing the Underlying Differences in Managing Sustainable Funds

We believe that it is first important to recognize that there are fundamental differences when managing sustainable investment funds. On the surface this may be obvious, but too often the differences between sustainable and non-sustainable fund management are given less attention than warranted. 

We think that these differences can be summarized in 3 ways.  First, it is important to understand that when managing sustainable funds there are distinctive sustainability-specific portfolio investment selection criteria and allocation overlay(s).  Sometimes these are straightforward, but they may also be complex depending upon a manager’s proprietary analytics and specialized investment focus.  These may be based on qualitative measures, but may also rely upon qualitative factors, and intangibles, making them more subjective when being interpreted.

Second, by their nature sustainable funds will have additional portfolio restrictions and limitations.  Again, some of these may be qualitatively-driven or intangibles.  For example, sustainability-factors are sometimes designed to reflect investor’s “values”, which leave room for interpretation.  These factors may not have clear-cut links to risk-return measures generally used in portfolio analysis and construction.

And third, managing sustainable funds can require customized and sometime unique analytical tools, and data.  Supporting these resources may require management team specialists who focus principally on sustainable issues.  This means that financial expertise that traditionally has been the core to making portfolio selection and allocation decisions should not be “confused” with that needed for sustainable fund management.

To further complicate matters, sustainable-fund managers use different portfolio management approaches, and as a consequence, the due diligence process needs to be adjusted for such variations.  These are discussed in the following sections.  To supplement this, we include an Appendix where we list specific questions that we feel are critical to conducting due diligence of fund managers using different sustainable investment approaches.

Different Questions for Different Sustainable Investment Approaches

A fund manager’s sustainability investment approach requires different lines of inquiry when conducting selection and oversight due diligence.  There are many areas of questioning that could and should be pursued depending on managers’ circumstances and their client’s requirements.  Below we identify some essential areas of inquiry for each of the five (for purposes of this paper, values-based investing and negative screening have been combined into a single approach) commonly used sustainable fund investment management approaches.

Negative Screening (Exclusionary) Approach

In some ways an exclusionary investment approach to sustainable fund management is the most straightforward to apply and oversee.  Defining the industries, sectors, activities, and sustainability-related concerns excluded from a portfolio is an obvious starting point.  It is, however, important to understand what criteria is used to make exclusions, if any, within selected industries and sectors.  These criteria and their weights should be defined for each industry, sector, or other excluded “category”. 

Managers using an exclusionary approach are increasingly applying “customized” processes to make selections within industries and sectors.  These processes allow a fund to hold positions in excluded industries and sectors depending upon a company’s exposure to various sustainability factors and controversies.  For instance, companies in an excluded industry may be invested in, depending upon the proportion of their revenues from carbon producing operations – more carbon-linked revenues means a smaller portfolio position, and vice versa.

The analytical framework, metrics, and their application should be examined for different market cycles.  This provides a basis for understanding how exclusions affect a fund’s performance and sustainability-risk trade-offs.  It is particularly important to identifying risk-return results that are due to sector concentration in the portfolio, and the manager’s method to control tracking error.

Thematic & Impact Investment Approach

When conducting due diligence of active managers employing an impact approach to sustainable investing, it is first necessary to identify the sustainability and/or controversy issues or themes being “targeted” for action.  Such action typically involves buying or adding to a company’s position in the fund’s portfolio. 

It is important to recognize that sustainability and/or controversy themes or issues are not constant.  They may change overtime given evolving public sentiment toward specific sustainability concerns.  These changes could affect not only the types of issues or themes focused on by a fund’s manager, but their relative importance in the investment process, and ultimately their portfolio weights.

The process used to establish sustainability themes should be closely examined.  This involves reviewing how the fund management team identifies pertinent ESG-issues, and then, selects and prioritizes investments and companies that could support a theme.  As part of this process, it is important to determine how a fund manager establishes impact outcomes and related benchmarks used to measure progress toward attaining a theme’s objective. Often this process involves a collaborative effort between fund management and various public and private sustainable investing interest groups.

Knowing how such impact actions have “played out” in the past should be questioned, including whether they succeeded as planned.  This is especially important when a portfolio manager intercedes and works directly with an “outside” interest group toward specific sustainability objectives.

ESG-Integration Investment Approach

The ESG-Integration approach to managing sustainable funds can take different forms and variations among managers.  An initial line of inquiry should be designed to understand how ESG factors are incorporated and weighed in the security selection process.  Portfolio weightings and allocations for ESG positions, if applicable, should be considered with respect to investment style, risk-return potential, and other financial criteria.  As part of this assessment, the question of how ESG factors are weighed against these other portfolio mandates and benchmarks. 

Often with bottom up selection approaches, companies are scored on the basis of their sustainability and/or ESG profiles.  Company quality scores are typically designed to measure ESG associated exposures, and integrated with other financial risk measures for purposes of modeling return opportunities and company valuations.  These ESG quality scores may use company data compiled in-house or acquired from a third-party provider.  In either case, added due diligence should be conducted into how these scores are constructed, the underlying data used, and how they compare with those of other out-sourcing services.

It is most important when overseeing managers using an ESG integration processes, that are becoming increasingly common, to examine their fund’s risk-return record and its responsiveness during various phases of the market cycle.  Emphases should be made to determine the effects on fund performance when portfolio changes are made as the result of variations in a company’s ESG quality score.

Engagement & Proxy Voting Investment Approach

Sustainable investment engagement processes utilize direct involvement by fund management with companies that the portfolio invests in.  Fund and company management typically interact in a joint effort to improve the company’s ESG quality.  Underlying these efforts, the goal is ultimately to maintain the company investment as a holding in a fund’s portfolio.  However, engagement actions increasingly involve fund managers using proxy voting actions to achieve specific sustainability-related objectives. 

When conducting due diligence of sustainable engagement portfolio managers, a first step is to identify specific companies and portfolio investments targeted for engagement, and why this is the case.  It is also important to explore what determines the level and nature of the portfolio manager’s involvement with each company?  This question has a practical aspect in that engagement initiatives involve resource commitments, and the fund manager must make choices as to which portfolio holdings offer the greatest potential for gains give management’s involvement.

The due diligence considerations for different sustainable fund investment approaches may overlap.  Further, within these approaches varying levels of due diligence analysis may be applied.

In the next section, we examine an area of due diligence that is applicable to each approach in equal measure – arguably this may be the most important area of oversight.

Assessing a Manager’s Corporate-Wide Commitment to Sustainable Practices

The internal corporate or business culture in which a sustainable fund manager operates, regardless of their approach, in many ways sets the context for assessing their due diligence results.  A fund manager’s corporate or parent company’s sustainable “culture” provides important due diligence insights.  Simply offering and managing sustainable funds does not necessarily mean that a firm is “dedicated” to sustainability practices.  Also, this cultural feature can change with time, especially as noted, when society’s views of sustainability issues evolve.

Areas of inquiry that provide some indication of an organization’s cultural commitment to sustainability include: the range of their sustainable-related products and services, their record of resource commitment to sustainability-related R&D; their planned business and organizational initiatives; and their sustainable investing staffing at different levels within the firm’s hierarchy.

A review of the firm’s internal policies and guidelines related to sustainability issues is important, as well.  It is important to evaluate the firm’s track record for sustainability issues, both directly and indirectly related to its primary lines of business.  While some firms have developed their own sustainability guidelines and policies, many rely solely on government issued regulations.  It is worth identifying the policy areas where the firm’s internal guidelines vary from those established by regulation.  How much attention has been paid to “living up to” these guidelines says something about the firm’s sustainable culture.

In summary, due diligence of sustainable managers and their funds requires added layers of specialized analysis.  These may require delving into areas and data not typically examined for non-sustainable managers and funds.  Moreover, while financial considerations typically associated with the due diligence process remain, their role should be expected to be augmented and in some cases, subject to analytical sustainability-related trade-offs.

Appendix – Important Questions for the Due Diligence of Sustainable Fund Managers

Negative Screening (Exclusions) Investment Approach

  1. What industries, sectors, and companies are currently excluded from the fund’s portfolio?
  2. What are the specific criteria used to designate excluded industries, sectors, and companies?
  3. Do these criteria and/or their weighting differ among companies, sectors and companies?
  4. Are these criteria the same across asset classes, and if not, how and why do they differ?
  5. Can exclusions be partial allowing the fund to hold some company positions in “excluded” industries or sectors?
  6. For companies in excluded industries or sectors, what financial metrics are used to determine allowable investment limits for the fund portfolio?
  7. Within excluded industries or sectors, how are company allocations for the fund’s portfolio defined?
  8. What event or development might change – tighten or lessen – an exclusionary designation?
  9. How is the fund’s tracking error controlled, and if required, are there portfolio strategies to offset for sustainability and/or controversies exclusions?
  10. Are the impacts of the fund’s sustainability and/or controversy-related exclusionary policies tracked overtime, and if so, what have been the effects on portfolio tracking error, risk-returns, construction, structure, liquidity, and other characteristics?

Thematic and Impact Investment Approach

  1. How are sustainability-related themes identified for “impact” investing by the fund?
  2. What investment parameters or limitations are established when defining a sustainable impact mandate for the fund?
  3. Are multiple themes or impact directives allowed for the fund, and if so, how are they prioritized and weighted for investment?
  4. Are non-management company “advocacy groups” involved in identifying investment themes or impact areas for the fund?
  5. Does fund management have established policies guidelines and restrictions for selecting and overseeing non-management company “advocacy groups”?
  6. Once a sustainable investing theme or area of impact is defines as a fund investment, how are projects and transactions evaluated, i.e., benchmarks established, monitoring processes and responsibilities, metrics and comparative base(s) used, etc.?
  7. What themes and areas of impact investing are currently being applied to the fund’s investments, and how do their results compare with their benchmark “targets”?
  8. For the fund’s current sustainable investing themes and areas of impact investing, what are their performance expectations and track record versus the fund’s benchmark?
  9. Have any changes – additions or deletions – to the fund’s themes and impact investments been made and why?
  10. Does the management company or its affiliates engage in structural transactions, and how is this managed?

ESG-Integration Investment Approach

  1. Why is the fund manager using an ESG-integration process – is it only applied for selected of its funds or strategies, or assets classes?
  2. How long has the fund manager used its current ESG-integration approach, for the fund and in general?
  3. How are ESG-factors defined, e.g. Company ESG associated risk, overall company ESG quality, or some other company “score”?
  4. Have the management company changed these ESG-factor definitions for the fund?
  5. Where in the manager portfolio investment process for the fund is: are ESG-factors incorporated, egg. Security selection, portfolio construction, etc.?
  6. Overall, how are ESG-factors weighed relative to other fund mandates including: financial growth, portfolio sector/industry exposure, investment style, and others?
  7. When using company ESG quality “scores”, are these compiled using the fund manager’s internal research – if yes, what ESG-factors, data sources, and weighting process and scoring models are used?
  8. Does the fund’s manager use a third-party independent source for company ESG-quality scores for some or all of the fund’s investments – is used for some, why those particular investments and not others?
  9. How and why does the fund’s ESG-integration process differ from the manager’s other funds and strategies, whether they be equity, bond, domestic or international/emerging securities?
  10. What have been the effects of integrating ESG-factors on the fund’s performance, risk, and other investment mandates, limitations and restrictions?

Engagement and Proxy Voting Investment Approach

  1. How are specific fund investments identified for engagement action – are there established manager and/or portfolio policies and procedures defining such actions?
  2. Does the portfolio manager act alone to initiate engagement actions, or are there “broader” firm-wide committee and policy guidelines employed?
  3. What are the primary sustainable investing considerations or factors leading to an engagement decision – are these “fixed” or defined on a case-by-case basis?
  4. Are there any over-riding policies or conditions to engagement decisions for the fund – who makes this “ruling”?
  5. Once an engagement has been decided upon, what is the process and steps for determining the level and nature of the fund manager’s involvement in a company?
  6. How is the level of company involvement determined – does this vary for active versus passive funds?
  7. How are the engagement processes measured and monitored by fund management – are there specific target results and time frames set?
  8. Are there limits on the number and types of engagement actions for the fund at a given time?
  9. What is the fund manager’s voting practices and policies, and who at the management company is responsible for the final voting decision?
  10. What is the fund’s proxy voting history and success result?

[i] Sustainable investing in an umbrella term that also refers to ethical investing, socially responsible investing and responsible investing.  It also seems that references to the term  sustainable investing is morphing into ESG investing.  Sustainable investing is the idea that investors can achieve a positive societal outcome or impact with their investments. Optimally, this should be accomplished without sacrificing long-term financial returns. While the definition has been changing over time, this concept today encapsulates a range of five overarching investment approaches or strategies. Most practitioners agree that these encompass the following approaches:  (1) Value investing, (2) Negative screening or exclusions, (3) Thematic and/or impact investing, (4) ESG integration, and (5) Shareholder/bond advocacy and proxy voting.

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