The ‘S’ in environmental, social and governance (ESG) has historically been the most neglected pillar of the three, but Covid-19 and stronger-than-expected returns have prompted a shift for pension funds, a new report has found.

Among 142 pensions funds surveyed with assets under management totalling EU$2.1 trillion ($2.6 trillion), 66% of respondents expect their share of social-related passive funds to increase over the next three years.

Currently, however, only 11% of respondents said they consider the ‘S’ pillar as the most important for ESG investments.

Unsurprisingly, 58% of respondents said they consider the ‘E’ pillar as the most important for ESG investments, while 31% said they consider ‘G’ the most pressing, according to a report published by UK-based research house CREATE-Research and sponsored by German asset manager DWS.

“The indications are that this is a long-term trend tying in with the broader uptake and development of ESG investing. We have seen significant demand for ESG passive solutions (be it ETFs or mandates) and I can only see that demand increasing further,” Simon Klein, DWS’s Frankfurt-based global head of passive sales told AsianInvestor.

Institutional investor confidence in ESG has been bolstered by the outperformance of companies with better ESG ratings compared with their lower-rated peers. In addition, the pandemic has prompted investors to demand investee companies disclose more information about employee relations and efforts to help local communities.

RISE OF ‘S’

The survey had similar findings – 59% of respondents said they increased allocations to the ‘S’ pillar because they saw the need to tackle the inequalities exposed by the pandemic.

In addition, 48% said they recognised that social issues do have an impact on business performance and investment outcomes and 58% are seeking good long-term risk-adjusted returns by investing in them. This was particularly important to them as pension funds because their liabilities stretch over the next 40 years, according to the report.

Simon Klein, DWS

“Generally speaking, companies with better ‘social’ scores, similar to companies with good ESG scores overall, tend to run more robust balance sheets, demonstrate consistent earnings and employ lower leverage – aspects that are captured through the quality factor in factor investing,” Klein said.

Eighty-one percent of ESG indices have outperformed their non-ESG indices since the March sell-off in 2020, according to the report, citing DWS estimates.

But while ESG funds have been proven to have the potential to outperform the market, investors should be conscious that it still takes considerable skill to construct an ESG-integrated portfolio that can perform well.

At a webinar attended by AsianInvestor in April, David Macri, chief investment officer of AustralianEthical, said that it is difficult to pinpoint ESG as a performance driver because ESG is not an asset class, and that it all “comes down to how you construct a portfolio”.

“This is an area that needs more research before we can draw any definite conclusions,” Klein said. “What we can say is that the more data we have over longer time horizons, the more confidence investors have with regard to the resilience of social-factor strategies, which help provide a forward-looking hedge against tail risks.”

“Also, at this stage clients are looking to limit their downside by constraining tracking error, with the majority of clients expecting 1% or less versus a standard index,” he added.

INVESTING FOR SOCIAL

Few pension funds are investing in vehicles that are specifically socially focused, as most of the pension funds (46%) surveyed said they use broader ESG indices and only 14% said they use core thematic social-related indices.

This could change as 26% of respondents said they planned to use core thematic social-related funds in the next three years – double those that currently adopt this practice.

Respondents also indicated that the use of social bond indices will rise from 6% to 28% in the next three years.

Source: Passive Investing 2021: Rise of the social pillar of ESG

One reason for the gap in social-focused investments is the lack of availlabilty.

Only two of 10 thematic sustainability indices in the marketplace cover the ‘S’ pillar, “forcing investors to make do with what is available”, the report wrote.

Klein also provided another reason: that the loose definitions for “social” – and ESG in generally for that matter – keeps investors from being able to select suitable funds.

“A lack of clear definitions and standards has been cited by 51% of respondents as a factor currently constraining them from investing in social-related funds,” Klein said. “From the findings, investors are tackling this shortcoming through three specific avenues: broad ESG themes, manager selection and more data.”  

Transparency between asset managers and clients is key for the growth of ‘social’ investing, Klein added.

“More transparency, more granularity of data, and a longer history of data and performance data will enable clients to assess an asset’s social performance,” he said, noting that after broad ESG indices, manager selection was the second-most popular avenue of choice for investing in social-related funds.

“Two-thirds of respondents look for the manager’s capability and track record to fulfill their social agenda, and 63% assess the manager’s stewardship and proxy voting track record in this regard,” he provided.