Call of (Fiduciary) Duty: ESG Matters

Error! Reference source not found.

2

Ca

ll o

f (F

iducia

ry)

Duty

: E

SG

Ma

tte

rs

Cancer foundations investing in tobacco companies, governments banning the use of cluster munitions

and yet financing their manufacture, FIFA’s corruption scandal – these are all clear breaches of

fiduciary duty: the broad responsibility to keep the interests and values of the client at the heart of

every decision. The root cause of such embarrassments can often be traced back to a systemic lack of

integration of ethical, social and environmental values. We believe embedding Environmental, Social

and Governance (ESG) issues as an integral part of fiduciary duty can help investors tackle such

challenges as it ensures that sustainability issues are front and centre in our investment decisions.

The trend towards responsible investment has sparked a great deal of debate in the world of finance.

Pension funds, family offices, asset managers, and other investment organizations across the

spectrum have now seemingly embraced the merits of integrating ESG issues into their investment

process. Indeed, more than 1,500 organizations have to date signed the Principles for Responsible

Investment (PRI [link: https://www.unpri.org/]), a set of guiding principles for incorporating ESG

issues into investment practice. Together, this collection of organizations represents more than USD62

trillion of assets, and includes actors with motivations ranging from contributing positively to future

generations, to mitigating long-term risks and enhancing reputations as investors.

Based on these numbers, we might assume that investing responsibly is a fundamental and widely

accepted part of fiduciary duty. But is that really the case? Looking at today’s investment landscape,

has the debate led to actual progress? Or is all the positive talk distracting us from the true reality of the

state of play?

The link between ESG and fiduciary duty

At Kempen, we strongly believe that embedding ESG factors in decision-making is a fundamental part

of the fiduciary duty of investors and key to the future development of our industry. Ultimately, it is a

way of seeing the big picture and consistently applying prudent principles while making investment

decisions.

However, this approach is not fully shared by all within the finance industry. Despite extensive research

attesting to the importance of ESG to long-term value creation, less than one percent of the total

capital of the 15 largest US public pension funds is allocated to ESG-specific strategies (ESG-screened

solutions, active management with ESG-insight, etc.) [[http://www.mckinsey.com/industries/private-

equity-and-principal-investors/our-insights/sustaining-sustainability-what-institutional-investors-should-

do-next-on-esg].]. If you look a little deeper, it seems short-termism persists in the financial markets.

Companies and investment managers often remain squarely focused on meeting quarterly financial

targets.

In addition, the market can be tinged with misconceptions surrounding fiduciary duty, with some firms

struggling to fully accept ESG issues as an integral part of that duty. Yet we live in a world where

financial and sustainability issues are becoming ever more tightly interlaced. By 2050, it is estimated

that the world will need to provide for as many as nine billion people against the backdrop of

diminishing land, water and natural resources, whilst battling such existential and fast-approaching

issues as climate change. In such a world, financial performance and sustainability are absolutely

interdependent.

Call of (Fiduciary) Duty: ESG Matters

Error! Reference source not found.

3

On top of short-termism and misconceptions, governmental bodies seem to be playing catch-up to

investor initiatives and are not always supportive of the changes needed to convince the laggards.

Take, for instance, the UK government in 2015 rejecting the Law Commission’s clear

recommendation that ESG should be taken into consideration while making investment decisions.

This was seen as a step backwards and the government’s acceptance of the status quo.

However, it’s not all doom and gloom – there are good examples of government involvement as well.

The French government has now obligated asset owners and managers to report on their carbon

footprint. [https://www.ipe.com/countries/france/france-aims-high-with-first-ever-investor-climate-

reporting-law/10011722.fullarticle] This is an example of the “push” side of the push-pull movement of

the industry towards ESG integration.

The pull side is also gaining traction thanks to voluntary actions by ESG trailblazers. However, in order

to really cement ESG’s position within fiduciary duty, the investment community as a whole needs to

embrace the work on the topic of responsible investment carried out by academics, scientists and

organisations such as the UKSIF (UK Sustainable and Finance Association), the PRI and the Kay

Review. Hundreds of articles and academic research papers have been written on the subject of

incorporating the ESG criteria into investment decisions. For a flavour of the reports on the topic of

sustainability, please see the research by CalPERS who have analysed over 800 academic studies.

[link: https://www.calpers.ca.gov/docs/governance/Archive/investments/siri-database-of-academic-

studies.pdf]. The underlying purpose of this review of evidence presented by CalPERS is to create a

searchable database of over 700 academic studies on sustainability factors spanning four decades of

research, which will allow us to examine the ultimate impact of these factors on investment risk and

return.

What can happen if nothing changes?

What if financial institutions continue to neglect ESG factors? Is it just a matter of some poor publicity

for asset managers? In fact, the consequences can be dire and the material risks to economic value

are clear to see:

Stories of the Enron fraud scandal, the Volkswagen emission scandal, BP and the Deepwater Horizon

accident; Mossack Fonseca and the Panama Papers; Toshiba’s accounting scandals; Valeant’s secret

division; Martin Shkreli’s HIV drug price hikes; Exxon Mobil’s deliberate misleading of the public on the

topic of climate change. The list goes on and on. Not taking the time to properly assess a company’s

risk profile can lead to the names of investors and pension funds appearing on newspaper front pages,

and ultimately destroy the value of the holding or damage the reputation of the asset owners. All of

these are clear examples of how affiliation (even if only perceived) with ESG issues can hurt the

reputation of the investor and financial performance of funds. Incorporating ESG into investment

decision-making provides no iron-clad guarantee that you will be spared such ignominies, but it does

logically decrease the probability of them occurring.

What next?

Simply agreeing on the importance of ESG value drivers is not enough to live up fully to our fiduciary

duty. At Kempen, our investment philosophy is based on a strong conviction that ESG risks and

Error! Reference source not found.

4

opportunities directly affect the long-term performance of a business and hence are an inseparable part

of our fiduciary duty. In other words, we firmly believe that companies must be in tune with society’s

needs in order to continue operating successfully in the long term.

‘Our favourite holding period is forever’

Though the saying was made famous by Warren Buffett, we too believe in long-term holding periods. A

preference for near-term results creates an atmosphere where tomorrow, and each day after, receives

less attention. Investing for the long-term, with a holistic understanding of fiduciary duty, shifts this

focus and allows investors to engage with the companies in which they invest on ESG issues instead of

simply selling the stock. Value creation takes place through a dialogue with firms, referred to as

engagement, by realigning management strategies for a sustainable economy. Find out more in this

article. [http://www.shiftto.org/paper---focusing-capital-on-the-long-term-by-barton-and-wiseman/]

At the heart of our investment philosophy is an explicit consideration of material ESG risks for every

industry and business. This can be done by both investing responsibly and creating a rigid system of

review to check that external managers are integrating ESG issues. At Kempen, we consider it vital to

assess the ESG performance of our external managers both during the rigorous due diligence process

and going further in the monitoring process with the manager.

Time of change

The world is changing. We are facing global economic challenges which can only be tackled effectively

together. No part of society will be left unaffected and the financial sector is no exception. To facilitate

forward-thinking decisions on behalf of clients in a challenging investment landscape, our society

expects full transparency from financial institutions regarding their responsibilities. PRI’s fiduciary duty

statement [] – which Kempen supported – represented a milestone on the path towards a holistic

approach to investment decision making. We strongly believe that owners and managers of financial

capital have a significant role to play in supporting enterprises which improve and protect the

sustainable economy. This approach is rooted in our more than decade-old European sustainable

[http://www.kempen.nl/asset-management/investment-funds/kempen-sustainable-european-small-cap-

fund-a/?langtype=1033] small-cap strategy and a newly developed approach of adopting a high active

share long-term portfolio, called Focusing Capital on Long-Term (FCLT).

Motivation for incorporating ESG into fiduciary duty may range from contributing positively to future

generations, to mitigating long-term risks and enhancing your reputation as an investor. In our opinion,

a responsible asset owner needs to know the holdings in their investment portfolio and understand the

ESG risks and opportunities of these holdings. Based on continuous ESG screening and dialogue with

companies in the portfolio, as asset owners you need to decide on your ESG strategy: do you exclude

potential controversial companies or start a dialogue to encourage positive change? Whatever you

choose, be transparent about it and report your policy and actions to your stakeholders. It sounds

simple, and actually it is.

Now it is time for the industry as a whole to act. Will you join us?

5