Research from Allianz's RCM is the latest of several studies to suggest that incorporating environmental, social and governance (ESG) issues into equity investment can boost a pension fund's returns.  Pension Funds Insider explores whether the arena offers pension funds a chance to secure real long-term returns in a world of uncertainty and market turbulence

Cynical investors have long suggested that investing on ethical grounds gains good publicity for a fund at the expense of returns. A recent survey of German institutional investors by asset managers Union Investments suggested 71% of those investing with a sustainability strategy do so to boost their image, while just some 40% said they expected higher investment returns.

A new RCM white paper, however, comes to the conclusion that "there is a probability of outperformance over the longer term" by using ESG in stock selection.

The research analysed equity price movements over the past five years compared to a company's ranking on the MSCI ESG rating indices and found that allocating to portfolios that invest in companies with 'best-in-class' ESG ratings can improve returns by 1.6% a year.

Pension Funds Insider consulted several leading figures in the ESG investing arena who lent their support to the research's findings and shed some thoughts on investing trends. Michelle Giddens, managing director of boutique ESG asset management specialists Bridges Ventures, said that "there has been a shift in investors mindset from seeing ESG in terms of risk to its ability to enhance value and provide returns".

Giddens explains: "Given the pressing environmental and social needs that our planet faces in terms of global warming and peak oil, companies that offer solutions to those needs have outstanding growth opportunities."

"Consider the alternatives asset class, which first developed for pension funds some three decades ago, many of the local authority pension funds were early adopters. I see environmental and social investing as having enjoyed a burst of interest in the first decade of the 21st century with increasing numbers of funds adopting it and I expect this to develop to a wider range of pension funds," she said. "Others will join in once they have seen the track record of the early adopters."

Bridges Ventures run a sustainable property fund and a venture capital fund that invests in high-growth socially responsible enterprises, boasting "top quartile" growth. They count a number of major public sector UK pension funds amongst their clients, such as the West Midlands, Merseyside and South Yorkshire pension funds along with the Railways Pension Company and the Universities Superannuation Scheme.

Peter Michaelis of Aviva is another ESG asset manager who can boast of funds that are "generally outperforming". Michaelas welcomes the RCM research as, like he says, it "is always a pleasure to have evidence that pension funds have nothing to fear from integrating more ESG analysis into their investment processes".

Michaelis claims that in addition to offering strong performance, ESG-focused equity funds also offer reduced risk.

"Partly ESG has been overlooked as it's one more thing to do for funds that generally have their hands full already. There's a common misconception that deciding for ESG means you miss out on investment opportunities, in a certain sector like tobacco for instance."

"We always stress that it's much more sophisticated than that, you can invest in tobacco but bear in mind environmental, social and government issues when choosing which companies to invest in. We look for positive companies that are safe investments over a long period of time."

The RCM research supports the trend amongst ESG investing to positively select good companies in mainstream asset classes rather than exclude bad ones. "That's definitely the direction of travel," says Michaelis.

Michaelis stresses that his Aviva funds asses companies "as if their corporate social responsibility people had all been sacked" to avoid deciding to invest in firms that are engaged in mere 'greenwashing'.

Michaelis insists providing solid returns are a more important feature of ESG-focused funds, saying "we definitely emphasise our returns rather than publicity value". "It is true that in some cases it would be bad publicity for a pension fund not to focus on ESG, but our reporting is all about pure investment performance and engagement performance."

Michaelis says that recent high-profile corporate governance failures may prove to be a catalyst for further interest in ESG equity funds. He says: "every time you have a BP event or News Corp type  of event, the argument gets stronger".

Michaelis believes that UK pension funds still have some catching up to do on many of the large continental pension funds, saying that "generally pension funds are more advanced on the continent in terms of integrating ESG in investing".

Those thoughts were repeated by Karina Litvack, head of governance and sustainable investment at F&C Investments, recent winners of a €6.5bn mandate from German pension fund BVK for their ESG engagement services. Litvack, who also mentions the fact that insurance giant Munich RE are engaging on ESG criteria, says: "We'll see a lot more happening in Germany with interest spreading from major public and organisation-specific pension funds to private re-insurers."

The Union Investments survey suggests two-thirds of German institutional investors incorporate ESG into their selections, and these considerations are applied to half their assets on average.

Litvack acknowledges that the take up of ESG investing amongst corporate pension funds in the UK, on the other hand, has plenty of room for development. "There's a nervousness about engagement that would mean a pension fund making judgements about a sponsor's peers or clients. These pension funds have deficits though, so sooner or later they will realise they have a greater shareholder base to serve and they will need to reflect the interests of their beneficiaries which are aligned to long-term sustainable investing."

Litvack echoed Michaelis in arguing that "we need to overcome the caution associated with ESG for restricting an investment universe".

First published 11.08.2011

dbillingham@wilmington.co.uk