An exciting Risk Alert from the SEC Division of Examinations popped up on my radar last week after the Commission’s recent review of Environmental, Social and Governance (ESG) related practices across asset managers and advisors. The verdict felt slightly damning. However, there was some light at the end of the tunnel as the SEC also highlighted best practices they expect will act as a model going forward.
Ultimately the criticisms were focused on inadequate controls and monitoring; inconsistent proxy voting; potentially misleading marketing claims regarding ESG approach; and lack of ESG knowledge or experience within the compliance function.
On the positive side of the ledger, several best practices were highlighted. These were simple and clear disclosures regarding the firms’ approaches to ESG investing: explanations regarding how investments were evaluated using global ESG frameworks, policies and procedures that addressed ESG investing and covered key aspects of the firms’ relevant practices, and compliance personnel that are knowledgeable about the firms’ specific ESG-related practices.
Now a long time ago when I was in school, we were taught how to write essays. Introduction about what you’re going to say, main body where you say it, and a conclusion where you summarize what you have just said. The SEC appears to be asking for nearly the same thing – a client-facing document where you describe what you are going to do, a process document where you explain how you are going to do it, and an oversight document where you prove you have followed your own rules.
Having talked to numerous asset managers and advisors, it is clear to me that these firms aren’t trying to mislead clients or regulators. Many have the right processes in place; they just aren’t very good at explaining or proving them. So, let’s look at these in turn.
What you are going to do
Client-facing material should outline your fund’s ESG objectives clearly and explain how you intend to measure them, the data provider you are using (or an internal process) and the specific metrics.
The Equality and Diversity Fund will seek to make above benchmark returns by investing in global equities that score in the top 25% of the following categories as calculated by Arabesque S-Ray.
- Human Rights
- Labour Rights
The average portfolio ESG score will not fall below 55 as calculated by Arabesque S-Ray.
Our US Environmental Focus Fund seeks to make above benchmark returns by investing in US equities that score in the top 10% of the following categories as calculated by Arabesque S-Ray.
- Water Waste
The portfolio will not invest in any company that receives over 5% of its revenues from thermal coal production.
How you are going to do it
Many asset managers and advisors use huge amounts of raw data to create their own selection process, which is their competitive edge. Generally speaking, their scoring system is specific to them and hard to describe in a simple client fact sheet. What we are seeing is that more companies are using their own selection criteria to create an investment universe, but then using independent scoring providers to manage the ESG exposures within these portfolios once the selection has been made.
If that’s your approach, it’s sensible to match the methodology of your provider to your internal system. Whilst the results may not always match perfectly (cue arguments over Tesla and BAT), using a third party gives you an independent check that prevents issues of greenwashing, and still allows you to run your selection process independent of the scores.
Having ESG scores available within your Order Management or Portfolio Management Systems, even in non-ESG portfolios, also builds awareness of how small changes in portfolio construction can hugely influence the portfolio’s overall ESG score. Over time, this awareness can make its way into the manager’s process. Having such data available directly in the software workflow also allows portfolios to be scored in real-time, rather than as an end-of-day or monthly snapshot. Furthermore it allows your orders to be exposed to ESG-specific pre-trade checks.
How you are going to prove it
The compliance function is often referred to in less than glowing terms by the front office as some sort of bogey man intent on stopping their fun. But when it comes to ESG mandates, strong compliance rules and structures are definitely a business creator. Clients want to know that you will do what you say, and unlike most mandates where there is purposeful wiggle room, it seems that clients are asking for much stricter controls in their ESG portfolios.
To achieve this, ESG data and scores (ideally from an independent data provider) must be fed into the compliance engine and held against each security. Either the compliance engine must be able to handle a huge number of data points, or it needs to be flexible enough to request just the data required for each rule.
Rules will need to be created and maintained, a record kept of every clean run and every compliance failure, and the results analyzed for recurring breaches that could be avoided. Once that is done, the results must be presented to the client – key metrics such as average portfolio scores, scores over time, percentage portfolio without sufficient data (conviction score), number of breaches and breach severity – to demonstrate the portfolio is adhering to the client’s guidelines. When it comes to these metrics, less is definitely not more.
In summary, the SEC Risk Alert indicates their expectation for the compliance structure to drive the mandate, rather than the other way round. In other words, you need to know what you are able to measure and control, and then offer portfolios built around that. Understand what data you can bring into your compliance engines, what rules you can create and maintain, and therefore what you can later validate with the client. Lastly, all personnel in the chain, from marketing to portfolio management, through to compliance, need to have at least a basic understanding of ESG and what their company means by that.
Companywide training is probably far more useful than having a small number of experts. After all, better a compliance expert learning ESG, than an ESG expert learning compliance! Having more sources of ESG expertise and experience across the organization engenders greater trust from the client, helps drive inflows and, hopefully, is also transformative for the manager themselves.
Is your firm positioned to join the ESG revolution?
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