A Framework for Responsible Investing

Euan Finlay

1 Sep 2019

A Framework for Responsible Investing

A Framework for Responsible Investing

Euan Finlay

While we have been discussing responsible investing with our clients for many years, we believe that institutional investing has reached a tipping point with many more institutions taking active decisions relating to how the construction of their portfolios impact the environment, social issues, corporate governance and behaviour. The growing focus on responsible investing tends to be the result of the evolving aspirations of mostly our institutional clients’ key fiduciaries and stakeholders to further contribute to the institutions’ stated core mission over and above the donations and grants of the endowment or foundation. This is also the result of a realisation that a proportion of their investment portfolio could be invested in sectors or companies which contravene the stated mission or ethics of the institution. Given the increased focus, we have updated our whitepaper on responsible investing primarily to articulate the framework we have created to help clients craft their own responsible investment policies. This paper also aims to provide clarity on the definitions of the various responsible investment sub-strategies which are often used interchangeably, academic research on the performance of such strategies, an update on the take-up of responsible investment policies by investors and detail on the improvements made in measuring the impact of various responsible investment strategies.

Given that the social and environmental causes that our clients support are personal and subjective, Partners Capital cannot recommend specific responsible investment policies for our clients. Nonetheless, we are pursuing our own desire “to make a difference” in two primary ways:

  1. by educating and assisting our clients to enable them to be leaders in the field of responsible investing while still achieving long term investment performance at the top of their peer group; and
  2. endeavoring to assist the asset managers in whom we invest to improve the degree to which environmental, social and governance factors are incorporated into their investment decision making process through sharing best practice. Influencing the behavior of our asset managers, who manage multiples of the total capital that we have invested in their funds, has the potential for Partners Capital to have a highly leveraged impact on the causes that are important to our clients and firm.

I. Definitions of Responsible Investment Strategies

Any discussion about responsible investing should start with clear definitions of the terminology as we find there is little consistency in how various terms are used. Impact investing, socially responsible investing (“SRI”) and Environment, Social and Governance (“ESG”) factor-based investing are often used too interchangeably for an implementation framework to be of use. We take most of the terms at their most literal and define them in table 1 below. We define “Responsible Investing” as those strategies which combine investors’ financial objectives with non-financial considerations, primarily environment, social and governance factors, into the investment decision making process. A responsible investing strategy could consist of any number of the subcategories defined in the following table.

Table 1: Definition of Responsible Investing Sub-Strategies

Source: Global Sustainable Investment Alliance and Partners Capital
Strategy Definition Investment Examples
Socially Responsible Investing A strategy that encourages investment in companies and funds that meet certain ethical standards, in order to generate both financial returns and positive societal impact. A catch-all phrase for any of the strategies listed below
Negative / Exclusionary Screening The exclusion from a fund or portfolio of certain sectors, companies or practices based on specific responsible investment criteria. Sectors most often considered for exclusion include tobacco, alcohol, gambling, arms and fossil fuels. Exclusion of tobacco companies from a portfolio
Sustainable Investing Rather than focusing on negative screening of sectors and companies, sustainable investing is a more positive approach. It is based upon a body of research that suggests that companies’ environmental, social and governance performance is intimately connected to their long-term financial performance. Sustainability can be used to describe investments in themes or assets that address specific issues such as climate change or food production. Portfolio of companies with low carbon footprint; companies focused on renewable energy generation
ESG Integration The systematic and explicit inclusion or integration by investment managers of environmental, social and governance factors into investment research and analysis. Portfolio invested in asset managers with formal ESG criteria in the investment screening process
Corporate Engagement and Shareholder Action The use of shareholder power to influence corporate behaviour, including through direct corporate engagement (i.e., communicating with senior management and boards of companies), filing shareholder proposals and proxy voting that is guided by ESG guidelines. This could also include engagement by limited partners with underlying asset managers. Vote shares based on investor’s ethical preferences
Impact Investing All investments in any asset class globally made with the intention of addressing social or environmental issues while generating a financial return. The impact could be explicitly related to the stated mission of the institution or addressing other societal issues. Given the wide variety of possible impact investments, institutions pursuing impact investments need to be clear about the particular impact that they wish their investments to have. For charitable organisations, this is generally very closely aligned with the charitable aims of the organisation. A healthcare endowment investing in a healthcare focused social impact bond; an educational endowment investing in a company providing loans to business school students from developing countries

For the purposes of this Partners Capital Whitepaper, we will use the term “Responsible Investing” to encompass all definitions above. Readers should think of this as the menu from which they can tailor their own responsible investment strategy.

II. The Growth of Responsible Investing and its Drivers

Professionally managed assets which employ a responsible investing strategy have grown dramatically over the last five years. Today, they are primarily concentrated in negative or exclusionary screening and strategies which integrate environmental, social and governance (“ESG”) considerations into the investment decision making process. The Global Sustainable Investment Alliance estimate that there were $31 trillion of assets managed with a responsible investing strategy in 2018. The impact investment market remains small with only $450 billion of assets but is growing rapidly from a low base. Figure 1 shows the total professionally managed assets by responsible investment strategy although that does not reconcile to the $31 trillion total due to double counting.

Figure 1: Growth of Responsible Investing Assets by Strategy (2014-2018)

Source: Global Sustainable Investment Alliance, 2018 Global Sustainable Investment Review.

The pace of adoption of responsible investing strategies is also illustrated by the growth in signatories of the United Nations Principles for Responsible Investment directive, an international body of investors which collaborates to implement responsible investment initiatives. At the end of 2018, there were 1,961 signatories who, in aggregate, manage $82 trillion of assets. This compares to 1,050 signatories with assets under management of $32 trillion in 2012. The asset management industry has responded to this growth in investor demand with both strong public commitments to responsible investment strategies and new fund launches. In an annual letter to company CEOs, Blackrock founder Larry Fink publicly demanded that each company must show how it makes a positive contribution to society. Similarly, Morgan Stanley has created the “Institute of Responsible Investing” tasked with integrating responsible investing strategies across all departments of their business. We have also seen a number of mainstream asset management firms launch impact investment funds including TPG, Bain Capital, KKR, Apollo and Wellington. Investors need to distinguish between those strategies launched largely as asset gathering tools for the managers and those with differentiated credentials in generating real impact.

This momentum is mirrored by the adoption of responsible or impact investing strategies by institutional investors although policies vary significantly. Many large quasi-sovereign institutions have well defined responsible investment policies. The Canadian Pension Plan fully integrates ESG into its investment decision making process. The Norwegian Sovereign Wealth Fund employs exclusionary screening and active corporate engagement in an attempt to improve the practices of its investee companies. Adoption in the United States has generally been slower than Europe. Nonetheless, notable examples in the US include the Ford Foundation which has pledged to invest $1 billion of its $12 billion endowment in mission driven impact investments.

This growth in the adoption of responsible investment strategies reflects the increasing desire of institutional investors and individuals to contribute towards social and environmental improvements. Studies have suggested that this evolution is partly a generational phenomenon with “Millennials” more embracing of these values than previous generations. A Morgan Stanley survey found that Millennials were nearly two times more likely to invest in companies or funds that target specific social or environment outcomes compared to the broad population(1). However, accelerated adoption is likely also a reaction to the increased awareness of these issues facilitated by technological advances in both measuring our impact on the environment and communicating that impact broadly. For institutional investors, notwithstanding the shifting sentiment of their stakeholders, responsible investment strategies quite simply provide additional tools to generate a positive impact over and above the grants from their endowments. They provide the investor with the opportunity to support companies and projects which improve the welfare of their stakeholders, the community and the environment. If effectively executed, the institution earns not only a financial return on its investment, but also generates a positive social and environmental impact.

III. Established guidelines for Responsible Investing

The United Nations supported Principles for Responsible Investment Initiative (UNPRI) is an international network of investors who have agreed to adhere to six principles which aim to integrate responsible investing characteristics into their investment strategy. Signatories include Harvard Management Company, the Canadian Pension Plan and Blackrock Asset Management. These principles, listed below, are the closest to a common global guideline for responsible investment strategies of asset managers that exists. Those investors that have documented a formal responsible investing policy have generally included elements of these six principles, which apply to both asset managers investing directly in securities and those allocating to third party fund managers:

  1. Incorporate ESG issues in investment analysis and decision-making processes
  2. Be active owners and incorporate ESG issues into ownership policies and practices
  3. Seek appropriate disclosure on ESG issues by the entities in which they invest
  4. Promote acceptance and implementation of the principles within the investment industry
  5. Work together to enhance our effectiveness in implementing the principles
  6. Report on activities and progress towards implementing the principles

While the UN PRI advocates ESG integration, which is among the most rapidly growing sub-sectors of the responsible investing universe, the most prevalent policy is still negative screening: the exclusion of sectors, companies or practices from an investment program based on their failure to adhere to specific responsible investment criteria. The Global Sustainable Investment Alliance found that of the $30.7 trillion invested in responsible investment strategies, $19.7 trillion involved some form of negative screening(2)
The UNPRI does not advocate which sectors investors should avoid and historically, investors have struggled to reach a consensus. However, those sectors that are commonly excluded from responsible investment programs include:

Fossil Fuel: hydrocarbon extractive industries are excluded by some investors particularly those focused on climate change. Please see table 2 below for the percentage of the MSCI All Country World Index that fossil fuels and other commonly excluded sectors account for.

  • Defense: contentious, with the social and political leanings of the investor guiding their strategy with regard to companies producing firearms.
  • Tobacco: generally regarded as an addictive and unhealthy product for consumers. Foundations with missions to improve access to healthcare and fund medical innovations often exclude Tobacco companies from their investment programs.
  • Alcohol: excluded for similar reasons as tobacco companies, but less consistently.
  • Gambling: often considered to be addictive with potentially destructive consequences.

Increasingly, advocates of negative screening are turning their attention to the food industry, particularly those companies which produce foods high in fat and sugar which have been blamed for obesity.

Table 2: Proportion of Global Equity Market Cap in “Sensitive” Sectors

Sector Percentage of MSCI All Country World Index(4)
Fossil Fuels(3) 6.1%
Aerospace & Defense 1.9%
Tobacco 0.8%
Alcohol – Brewers, Distillers and Vintners 0.9%
Casinos and Gambling 0.3%
Total “Sensitive” Sectors 10.0%

In total, we estimate that the companies operating within “sensitive” sectors that have been excluded from responsible investing mandates account for c. 10% of the total market cap of the global equity market.

The Norwegian Sovereign Wealth Fund (5) produces a list of individual companies that it excludes from its portfolio. As of 30th June 2019, this list included 155 companies. It goes a step a further than screening purely on sector grounds, as companies are also excluded for idiosyncratic reasons related to their specific corporate behavior including environmental damage and violations of human rights. Other investors exclude any company which contravene the key principles of the UN Global Compact which outline the minimum responsibilities in the areas of human rights, labour, environment and anti-corruption.

IV. Institutional Investors’ Responsible Investment Policies

Partners Capital conducted an independent review of the responsible investment policies of investors whom we believe to be amongst the most sophisticated members of the institutional investment universe. There is a wide range from strict integration of ESG criteria in the investment strategy to none at all. The Canadian Pension Plan and Norwegian Sovereign Wealth Fund are at one extreme. Both are signatories of the UNPRI and explicitly integrate responsible investing criteria into their investment processes. The Princeton University Endowment is at the other extreme, with no responsible investment strategy as of this writing. Others have adopted strategies which explicitly exclude investments in specific sectors or geographies. For example, the Wellcome Trust, a £25 billion UK based charitable organisation dedicated to improving global health, structurally screens out tobacco companies from its endowment. Similarly, the Bill and Melinda Gates Foundation excludes tobacco companies and all enterprises carrying out operations in the Sudan from its portfolio. A number of the large US educational endowments, including the Yale University endowment, have established advisory boards which provide recommendations to the investment office on responsible investing issues. The advisory boards typically consist of a broad range of stakeholders in the endowment including students and faculty members. However, experts can be consulted for the review of specific topics. The scope of the recommendations has been wide ranging, from guidelines for the voting of shares to the exclusion of particular investments from the portfolio. Through consultation with the advisory board, Yale have generally not excluded sectors from the portfolio, although there are notable exceptions such as assault weapon retailers. Yale’s approach has been to engage with underlying company management as a shareholder. An example is in the fossil fuels sector, where rather than embracing a blanket policy of divestment, Yale’s Chief Investment Officer, David Swensen, wrote to all underlying asset managers in the portfolio. Specifically, Yale asked that when investment decisions were made by underlying managers, an assessment was made of the greenhouse gas footprint of that investment and the impact on expected returns for the portfolio from both the direct costs related to the consequences of climate change and any potential future regulatory driven costs. This action was taken in conjunction with the school’s broader policy of development of energy efficient buildings and the creation of research posts focused on climate change.

Table 3 provides a brief summary of the responsible investment policies of other highly respected institutional investors (5)

Institution Type of Institution Total Assets ($B) Signed a Responsible Investment Initiative Are Sectors Screened Out of Portfolio? Description of Responsible Investment Policy
Harvard Management Company University Endowment 39.2 UN PRI Tobacco Three-pronged responsible investment approach: 1) integrate ESG criteria into due diligence; 2) engagement with portfolio companies on ESG risks; 3) collaboration with global investors to develop best practices.
Yale University University Endowment 29.4 No Yes. Companies conducting business in Sudan and Assault weapon retailers Guided by an Advisory Committee on Investor Responsibility. Provides guidelines on the voting of shares which is generally to vote in favour of propositions which minimise “social injury”. Asked managers not to hold companies that refuse to acknowledge the costs of climate change and fail to take economically sensible steps to reduce greenhouse gas emissions.
Stanford University University Endowment 26.5 No Presumption against divestment but possible in certain circumstances Investment process actively incorporates ethical and social consideration to help achieve its goal of maximizing risk adjusted returns. The portfolio is invested predominately in third party managers so, in practice this means assessing the skill of those managers at incorporating such considerations.
Princeton University University Endowment 25.9 No No No responsible investment policy. Overall investment policy is to maximise returns subject to risk constraints.
Oxford University Endowment Management University Endowment 4.4 Institutional investors group on climate change Tobacco, coal, oil sands, weapons illegal under UK law Responsible investment criteria incorporated in a variety of ways including exclusions, voting shares, collaboration with other groups and funding early stage innovative companies
Wellcome Trust Charitable Foundation 32.3 No Yes. Tobacco The Trust regards “stewardship” as integral to the process of equity investment. Engage with management to raise issues relating to a company’s strategy, including governance. Where investments are held through third party managers, that manager’s approach to stewardship is reviewed as part of the due diligence on the manager.
Bill and Melinda Gates Foundation Charitable Foundation 41.3 No Yes. Tobacco and companies conducting business in Sudan The Foundation believes that businesses can play a crucial role in helping to solve social problems and the foundation can have an impact by directly encouraging those businesses to dedicate expertise and money to help solve those problems. The foundation guides third party managers to integrate ESG considerations into their investment decision making and when voting proxies.
Canadian Pension Plan Pension Fund 264.6 UN PRI No CPP believe that over the long term, ESG factors have the potential to be significant drivers of corporate profitability. Their approach includes integration of ESG factors into the due diligence process, engaging with company management teams in areas such as governance, proxy voting and collaboration with other long term investors. The organization have also issued Green Bonds.

V. Responsible Investment Strategies for Partners Capital Clients

The decision-making process regarding whether to pursue a responsible investment strategy begins and ends with the investor. Partners Capital cannot provide advice as to how an investor should feel about particular strategies or whether certain sectors should be avoided. However, we can provide a framework for how our clients can think about their responsible investment policy and its potential impact on portfolio construction and return expectations.

Institutions with defined purposes face a trade-off. Their success is measured by the impact they have in achieving that purpose, whether it be, for example, furthering medical research, providing educational improvements within certain populations or contributing to the arts in a certain community. A number of institutions have made the decision that the greatest impact they can have is through the maximisation of returns on their investments in order to maximise direct grants in the areas they are seeking to impact. Those institutions have typically come to the conclusion that responsible investment strategies have the potential to impose a cost on investment performance or that their ability to create meaningful positive impact through their investment strategy is limited. It also requires the investor to accept the conflict that their investment portfolio could be invested in sectors or companies that are at odds with the overriding missions of the endowment.

However, as outlined above, institutional investors are increasingly reaching the conclusion that their mission can be most effectively executed through a combination of direct grants and through the way in which the endowment is invested. Below, we lay out the four principle options for responsible investment policies that institutional investors can adopt. In addition to a decision about the nature of the overall responsible investment strategy, the investor needs to decide on the proportion of the assets in the portfolio which will comply with that strategy.

  1. Exclusionary screening: Under the “no harm” principle, portfolios may be constructed to exclude certain companies which produce goods or services which do social or environmental harm or have undesirable employment practices. This could include certain sectors such as tobacco or certain stocks, such as those on the Norwegian Sovereign Wealth Fund’s exclusion list. In addition to deciding whether to include negative screening in the investment strategy (and which sectors / stocks should be excluded), the endowment also needs to decide the proportion of the portfolio that this policy applies to. This could apply only to the endowment’s passive investments and those over which it has direct control. Alternatively, it could be applied to all assets in the endowment which would require compliance of all the underlying active managers.
  2. ESG Scoring: An alternative method of screening portfolio companies is through the use of ESG scoring systems from providers such as MSCI and Sustainalytics. Companies are ascribed a score based on their performance on various ESG factors. Institutional investors can score their underlying portfolio companies and compare to a passive index, such as the MSCI World Index, or a  predefined threshold target score. This is most easily implemented for institutions with direct equity investments although possible via third party managers.
  3. Integrate ESG criteria into the investment decision making process: This is a policy advocated by the UNPRI which involves non-financial criteria being factored into all investment decisions made by the endowment. Again, similar to the negative screening policy, there is a spectrum of ways in which this could be implemented in practice with decisions required on the threshold minimum level of integration and the proportion of the portfolio which should be compliant. For our clients who invest predominately through third party asset managers, ESG integration is measured by assessing the policies and practices of the underlying managers via our proprietary survey and scoring system. Central to ESG integration is engagement with the underlying asset managers; both to ensure that the managers are striving to improve their ESG integration practices over time but also to ensure that the asset managers are engaging with underlying company management teams to influence their behaviour in a way that is supportive of good corporate governance, environmental policies and social practices. This is a big commitment and it is questionable what impact is really possible through such engagement by any one institutional investor. That being said, it may be more practical to engage an external investment advisory service that, in addition to providing overall investment advice, will engage with the third-party asset managers to monitor and encourage adoption of policies in support of the investors’ desires for environmental, social and governance related investing criteria and engagement with company management.
  4. Impact investing: This strategy involves any investment in any asset class which the investor believes can have a positive impact on specified social or charitable missions, purposes or aims whilst also generating a financial return. Whilst an exhaustive list of all impact investments is too long for the purposes of this paper, most can be grouped under the following three broad categories:

    • Direct equity or debt investments: includes the investment in public or private enterprises that the investor believes positively impact society in a way that is consistent with their aims. This can be as varied as directly held equity investments in listed companies to the private financing of social enterprises. By way of example, charities focused on the preservation of the environment could hold a portfolio of investments in the listed equity of renewable energy companies. This is a form of “positive screening”. Over the last 30 years, the MacArthur Foundation has managed a missionrelated investment portfolio totaling over $500 million. Their underlying investments take the form of loans, equity and guarantees designed to meet the capital needs of special purpose funds, for-profit businesses and nonprofit organisations tackling environmental and social challenges around the world. Examples of such investments have included 10-year loans with 1-2% interest rates aimed at supporting community development and the preservation of affordable rental housing(6). However, this method of impact investing is resource intensive and requires considerable in-house expertise which can limit its use to only the larger foundations. Other examples include green bonds, which is debt issued by companies and sovereigns with the proceeds specifically earmarked for climate and environmental projects.
    • Third party funds with a social impact mandate: investments in the funds of third-party asset managers that typically have the dual purpose of generating financial returns along with a well-defined social impact. The investment’s success is judged on both criteria. The social impact pursued by these funds varies widely by scope, geography and subject matter. The Bridges Ventures Sustainable Property Fund invests in commercial property located in relatively deprived boroughs in the UK with the intention of catalysing the regeneration of the surrounding area. In contrast, the Bain Double Impact Fund has a much broader mandate, investing across sectors and regions in the United States. A number of impact investment firms are focused on emerging markets where their actions can influence the lives of large number of traditionally underserved individuals. An example is Leapfrog which invests in financial services and healthcare business in Asia and Africa which are aligned with selected UN Sustainable Development Goals. They have also developed a proprietary framework to measure outputs and outcomes across the businesses in which they invest. Institutional investors must decide whether the impact pursued by the fund is suitable for their particular mandate or mission.
    • Social impact bonds: contracts with the public sector which allow private investors to finance an activity which is designed to lead to an improved social outcome. The investors are paid a rate of return which is dependent on the success of that activity in improving the issue that the bond was raised to address. One of the higher profile social impact bonds in the UK was raised to reduce re-offending amongst short-sentenced male prisoners leaving Peterborough prison. Many other social impact bonds have been raised including those focused on supporting disadvantaged young people in their search for employment in East London and reducing youth homelessness in West Yorkshire. In this way, social impact bonds allow investors to isolate a very specific issue that they wish to support.

The social and environmental causes that our clients support are highly personal and subjective. As mentioned, we educate and assist our clients in the creation of bespoke responsible investment policies given those beliefs and build portfolios which adhere with those policies. However, our recommended approach embraces pro-active engagement with asset managers to encourage increased integration of environmental, social and governance (“ESG”) considerations into the decision-making process. This is borne out of the belief that the incorporation of ESG considerations in investment decision-making will result in improved risk adjusted returns over the long term. Accordingly, while the policies of individual clients will vary, our due diligence process is consistent and includes rigorous assessment and scoring of the degree to which ESG considerations are taken into account. We also believe that the most leveraged impact that Partners Captial can have on the world as a force for good is through the encouragement of our asset managers to improve their policies in this field.

VI. The Impact of Responsible Investing Strategies on Returns

The question we are most commonly asked on the topic of responsible investing is whether adoption of such policies negatively or positively impacts financial returns. A large body of academic research has been produced addressing this question with the general conclusion that responsible investment strategies are able to produce “market rates” of return. However, the area of academic research which is least developed, and we believe to be of paramount importance to institutional investors predominately invested in third party managers, is the return implications of reducing the universe of asset managers by excluding those that do not adhere to a pre-determined threshold of ESG integration. In our experience, many asset managers who we believe have the ability to generate persistent alpha, have not yet fully incorporated sustainable investing strategies. Our expectation is that those managers will increasingly incorporate ESG factors into their processes through pressure from limited partners. However, we believe that today, the strict adherence to threshold levels of ESG integration would result in a reduction in the available universe of strong-performing asset managers.

The academic research has primarily focused on three methods for analysing whether there is a financial performance differential between traditional and responsible investment strategies, which largely follow our framework of the three principle responsible investment policies that can be adopted:

  1. Comparison of mainstream equity indices to their sustainable investment index fund counterparts. These studies test the performance impact of exclusionary screening. The academic studies find minimal difference in the performance of sustainable and traditional indices over the long term. For example, the MSCI KLD 400 Social Index is widely used to provide investors with exposure to those companies whose products are not considered to have a negative social or environmental impact. The constituents have been selected from the MSCI USA IMI index. The overall composition of the 400 Social Index has been designed to mirror the parent index’s sector and market cap characteristics. Over the past five years, the performance of these two indices has been broadly similar as shown in the table below. The table also includes the S&P 500 Index as a comparison to a more commonly held equity index, which has also generated very similar performance. Various academic research papers have employed this methodology of comparing the performance of responsible equity indices with unconstrained indices and controlled for any sector or style biases introduced through the exclusion of certain stocks or sectors. The conclusions are the same; performance of the two indices are broadly similar over the long term.

    Table 4: Performance of MSCI KLD 400 Social Index Versus Traditional Equity Indices

    Source: Bloomberg
    2010-2018 Annualised Performance
    MSCI KLD 400 Social Index 11.2%
    MSCI USD IMI Index 11.7%
    S&P 500 Index 11.7%
  2. Comparison of the share price performance of companies that score highly on ESG criteria versus the broader index. Various studies have found a positive correlation between company scores on ESG criteria and financial performance. Kempf and Osthoff (2007) found that a long-short strategy (long stocks with high ESG ratings and short stocks with poor ESG ratings) could yield c.9% alpha per annum for a concentrated portfolio7. Statman and Glushkov (2008) reached a similar conclusion and highlighted community, employee relations and the environment as the factors which had the largest correlation with positive performance(8). That said, research by quantitative investment firms including CFM and Arrowstreet is more mixed. Their research generally supports the positive correlation between higher ESG scores of underlying companies and share price performance. However, this is largely due to the “Governance” score  within the overall ESG score which is closely correlated to “Quality” and “Low volatility” factors, both of which have had positive returns. The practitioners acknowledge that they have insufficient data following the dramatic change in investor preferences with regard to ESG factors to draw firm conclusions.
  3. Comparison of the realised returns of funds which explicitly target specific impact versus equivalent traditional funds. These studies test whether a market rate of return can be generated from impact investments. A widely cited study was a collaboration between Cambridge Associates and the Global Impact Investing Network to create a private equity impact investment benchmark. While a small sample set for this relatively nascent industry, according to this study, the average impact investment fund has returned +7.1% per annum in the ten years to 31st December 2018. This has lagged the Preqin Private Index which returned +12.9% per annum over the same time period. However, this data also proved that a subset of the impact investment funds outperformed the private equity market. In the end, definitive conclusions on the relative performance of the impact investment industry are difficult to reach at this stage due to data limitations.

Insufficient published academic research is available on the performance impact of excluding managers without a threshold level of ESG integration from investment portfolios. The strength of the incumbent active manager line-up in any portfolio compared to the best managers with responsible investment policies determines the cost of full compliance with a policy of ESG integration. While the jury is still out at this point in time, we are certain that as responsible investing becomes increasingly important to investors, many of the most highly rated active asset managers will refine their policies to be more aligned with their investors suggesting that any performance impact could be temporary.

VII. ESG and Impact Measurement

Partners Capital believe that ESG measurement is a key link in a virtuous circle which connects the integration of ESG best practice by companies to long term share price performance. As ESG measurement becomes more reliable, institutional asset management firms could increasingly be evaluated both on their financial performance and the ESG scores of their portfolio companies. In an attempt to improve their portfolio ESG score, institutional investors may migrate their portfolio towards those companies with stronger ESG scores. The weight of capital migrating towards companies with strong ESG scores should result in share price appreciation of such companies. Company management teams see that share prices are rewarded for this behavior and increasingly take active decisions to improve their environmental and social impact and work toward best practices in corporate governance. These decisions should result in a tangible improvement in the environmental, social and governance outcomes associated with those companies, leading to improvements in the ESG scores; and so on. This virtuous circle is outlined in Figure 2.

Figure 2: ESG Measurement Virtuous Circle

ESG and Impact Measurement Methodology

There are currently two different levels of measurement of ESG scores and impact: 1) the direct and specific impact an investment has on a predefined objective (e.g., on literacy rates); and 2) the scoring of a company based on a broad set of predefined ESG criteria. To overlay these on our virtuous circle described above, the scoring of companies on ESG metrics is the key measurement technique required for benchmarking institutional investors which could lead to direct impact on specific outcomes via corporate actions. We briefly explain direct impact measurement prior to a more detailed explanation of ESG scoring techniques. While there is extensive research being conducted on this topic currently, the measurement of impact usually still takes the form of a number of specific metrics which the investor believes to be pertinent to the social or environmental issue being addressed through an investment. For example, an impact investment in a hospital in a rural region of an emerging market could be judged based on pre-defined metrics such as the increase in the number of hospital beds, the number of patients treated, the time saved in travel time to the previous nearest hospital and the number of lives saved. Both impact funds and traditional asset managers alike are beginning to produce annual reports which monitor the improvement of such metrics during the life of their investments.

ESG measurement, more often used by public equity and credit investors, are rating systems which assign each company in a portfolio a score based on performance against specified ESG factors. For example, MSCI ESG research evaluates 37 key ESG issues including carbon emissions, labour management, product safety and tax transparency for c. 10,000 companies globally. The performance of the company against each of these factors is aggregated to a single score per company allowing comparison of a portfolio against the broader index or a peer group. The process of creating the aggregated ESG score is developing rapidly. Whilst it incorporates the publicly announced information of the underlying companies,  it increasingly uses primary data from third party nongovernmental organisations and charitable foundations with expertise in certain areas.

Figure 3: MSCI ESG Rating Methodology: 10 Core Themes and 37 ESG Issues

Source: MSCI ESG Rating Methodology. * and ** indicate factors that are universal for all companies. The others are selected on an industry by industry basis.
3 Pillars 10 Themes 37 ESG Key Issues
Environment Climate Change
Carbon Emmisions *
Financing Environmental Impact
Product Carbon Footprint
Climate Change Vulnerability
Natural Resources
Water Stress *
Raw Material Sourcing
Biodiversity & Land Use
Pollution & Waste
Toxic Emissions & Waste *
Electronic Waste
Packaging Materials & Waste
Environmental Opportunities
Opportunities in Clean Tech
Opportunities in Renewable Energy
Opportunities in Green Building
Social Human Capital
Labour Management *
Human Capital Development
Health & Safety *
Supply Chain Labour Standards
Product Liability
Product Safety & Quality
Privacy & Data Security
Chemical Saftey
Responsible Investment
Financial Product Safety
Health & Demographic
Stakeholder Opposition
Controversial Sourcing
Social Opportunities
Access to Communications
Access to Health Care
Access to Finance
Opportunities in Nutrition & Health
Governance Corporate Governance *
Board **
Ownership **
Pay **
Accounting **
Corporate Behaviour
Business Ethics *
Corruption & Instability
Anti-Competitive Practices *
Financial System Instabilty
Tax Transparency

The increased demand for ESG scores of underlying companies has resulted in an increase in third party data providers. MSCI, Sustainalytics, Bloomberg and State Street are a small subset of the firms that produce ESG scores for public companies. Each has varied methodologies for arriving at such scores. RepRisk, another third-party data company, provide a dynamic score of the potential reputational risk for an investor for being associated with a certain company based on their assessment of the potential for the company to engage in activities which would result in adverse publicity. Arabesque, a hedge fund and data provider, use a proprietary quantitative approach to aggregate the scores of a selection of underlying data providers to arrive at both ESG scores for a company but also an assessment of the extent to which the company adheres to the UN Global Compact principles including human rights and anti-corruption.

Current Impediments to ESG Measurement Common Standards

Our thesis regarding the virtuous circle linking measurement of ESG factors to share price performance is predicated on the industry coalescing around a common measurement system. However, the corporate financial and impact reporting practices are far away from agreeing any such standard, primarily due to the difficulty of applying one measurement system to companies across all sectors and geographic markets. To complicate matters more, there is a vast array of providers of ESG metrics using different source data and different methodologies to aggregate this data into a specific score. Whilst the growth of companies choosing to disclose ESG data is encouraging (85% of S&P 500 companies published sustainability reports in 2017, compared to 20% of companies in 2011(9), the number of competing standards for disclosure of ESG data creates confusion. Companies may choose to report ESG data according to wide array of standards, including TCFD (Task Force on Climate-related Financial Disclosures), SASB (Sustainability Accounting Standards Board), GRI (Global Reporting Initiative), IIRC (International Integrated Reporting Council) or the UN SDGs (United Nations Sustainable Development Goals), to name a few. Accordingly, there is no agreed framework for how companies provide such data to the public markets. Furthermore, aggregating ESG data into ESG scores is highly fragmented, with over 150 organisations selling such services to investors10. Each provider uses different input data and different methodologies to arrive at their scores. Therefore, there is limited correlation between the ESG scores for a specific company from the major third party ESG scoring companies. Secondly, the factors that are most important for different companies vary widely. For example, the most pertinent ESG issues for a mining company are likely to be related to its environmental impact. Conversely, a financial services company is unlikely to have a major environmental impact but the governance issues, particularly anti-corruption, could be particularly important. This makes direct comparison of these companies, on ESG grounds, challenging. The future of ESG measurement will be around refining the tailoring of measures to individual industries, geographic markets and company size. We continue to believe that the improvements in measurement of ESG factors will translate into observable share price performance. The field of ESG measurement is rapidly evolving with many investors besides ourselves putting more attention on measurement that should result in a more effective link between ESG performance and financial performance. We will continue our efforts to drive the industry toward those dynamic measurement standards primarily through interaction with our managers.

Partners Capital Responsible Investment Dashboard

For many of our institutional clients, we track the adherence of their portfolios against their specific responsible investment aims and report on progress through what we call their Responsible Investment Dashboard. An example client report is shown in  Figure 4. The report has four metrics which closely adhere to the principle responsible investment strategies outlined herein. The first metric is the allocation to “sin sector” stocks within the public equities portfolio of the client in comparison to the allocation within MSCI World.

Figure 4: Example Partners Capital Client Responsible Investment Dashboard

This allows clients with exclusionary screening strategies to monitor their look-through exposure to those sectors which they may wish to avoid on ethical grounds. The second metric is the ESG measurement score of the public equity portfolio, as described above. This provides clients with an understanding of how well the underlying companies in the portfolio perform from an ESG perspective relative to the broad equity markets. As described above, it is our expectation that, increasingly, investors will tilt portfolios to those companies which score well from an ESG perspective rather than strict exclusionary screening of certain companies. The third metric tracks the degree to which the underlying asset managers in which the client portfolio is invested incorporate ESG factors into their decisionmaking process. This is obviously an important metric for those clients, predominately invested via third party asset managers, who adopt an ESG integration strategy. Prior to approval for investment by our clients, all asset managers are required to complete our “ESG integration questionnaire” measuring the degree to which underlying asset managers integrate ESG into their investment process. Managers are assessed across a range of topics and scored 1, 2 or 3 for each criteria depending on their policies and practices. These scores are then aggregated at the manager, asset class and overall portfolio levels. Finally, our responsible investment dashboard also includes short descriptions of specific impact investments made by the investor. These are typically investments into areas that are aligned with the mission of the charity or family investors and are most typically drawn from our private equity portfolios but can include public companies as well. The value of the ESG Dashboard is found in investors setting multi-year targets for achieving measurable improvements across all four of the areas with particular focus on ESG integration among the asset managers comprising the overall portfolio.

VIII. Conclusion

Interest in responsible investment strategies has grown rapidly in recent years, led by the growing desire of investors to contribute towards social and environmental improvements in the world. Our client base has embraced that trend with increasing requests for advice regarding the incorporation of responsible investment policies. This whitepaper highlights the choices that we believe our institutional clients have available to them if implementing a responsible investment strategy: 1) introduce negative screening criteria to the investment process, 2) ESG scoring of the underlying companies within the portfolio; 3) employ an ESG integration approach which would typically result in setting a threshold level of ESG integration that underlying asset managers must adhere to for inclusion in the portfolio; and 4) introduce an allocation to impact investments. In Table 6 below, we have laid out these options and the specific set of questions any investor must answer as part of formalising its Responsible Investment policy. We strongly encourage our clients to be leaders, rather than followers, in the investment industry when it comes to the development of a responsible investment policy. ESG investment strategy will increasingly be in the spotlight. Just like any other investment strategy, no investor wants to be late to the party. Early adopters, keenly focused on the mistakes and learning that  others have, should benefit the most.

Table 6: Framework for Crafting a Clear Responsible Investment Policy

Description of Responsible Investment Policy Foundation Investment Committee Policy Decision Options
Negative / exclusionary screening of companies
  1. Define which sectors are to be excluded from list / or named companies (tobacco, spirits, gambling, arms, fossil fuel)
  2. Decide what is a tolerable look-through exposure to each excluded sector (or group of companies)
  3. Replace existing passive funds with ESG passive index funds
  4. Decide which active managers will be excluded due to excessive exposure to excluded sectors; OR
  5. Decide a threshold ESG score that the equity portfolio must adhere to. Asset manager, direct stock and passive index tracker selection would then be governed, in part, by adherence to the threshold scoring target
ESG scoring of underlying portfolio companies
  1. Decide on the third party provider of ESG scoring metrics
  2. Decide whether applicable to directly held stocks or those stocks held via third party managers
  3. Decide upon the methodology for determining threshold levels of ESG scores which could be an overall portfolio average score or an absolute threshold above which all investments must sco
  4. Decide upon the migration plan to target
Integrate ESG criteria into the investment decision making process
  1. Decide what is the threshold level of ESG integration that you are seeking your asset managers to comply with
  2. Decide what % of asset managers must comply with the above ESG integration threshold and over what period of time
  3. Decide the extent to which you will work with managers to adopt suitable ESG integration policies
Social Impact investments made in support of the foundation’s mission
  1. Define what social causes to support
  2. Define the allocation of the overall portfolio to impact investing
  3. Evaluate and choose specific investments
  1. Morgan Stanley. “Sustainable Signals: The Individual Investor Perspective.” Morgan Stanley Institute for Sustainable Investing (2015).
  2. Global Sustainable Investment Alliance. “2018 Global Sustainable Investment Review”
  3. Includes the following sectors: integrated oil & gas, oil & gas storage and transportation, oil & gas refining and marketing, oil & gas equipment and services, oil & gas exploration and production, coal and consumable fuels.
  4. Analysis of world market cap based on the constituent weightings of the iShares MSCI World All Country World Index.
  5. Norges Bank Investment Management website.
  6. The forum for Sustainable and Responsible Investment. “Unleashing the potential of US Foundation Endowments: using responsible investment to strengthen endowment oversight and enhance impact.”
  7. Kempf, Alexander, and Peer Osthoff. “The Effect of Socially Responsible Investing on Financial Performance.” European Financial Management (2006).
  8. Kempf, Alexander, and Peer Osthoff. “The Wages of Social Responsibility.” Financial Analysts Journal 65, no. 4 (2009).
  9. Governance & Accountability Institute, “85% of S&P 500 Index® Companies Publish Sustainability Reports in 2017”, (Mar. 2018)
  10. TruValue Labs: ESG Ratings and Rankings All over the Map. What Does it Mean?