Why overly prudish ESG-focused pension funds could suffer

Pension funds wrestled with ESG responsibilities risk having a detrimental long-term effect on their returns if they make too many ethical exclusions in the short term.
Why overly prudish ESG-focused pension funds could suffer

With environmental, social, and governance (ESG) concerns increasingly at the top of investors’ minds, questions are arising about how much sustainable investment funds should respond to some pension members’ desire to exclude companies they dislike.

ESG investing experts at a conference on Wednesday (September 10) argued that pension funds that get too carried away with excluding the assets of companies whose behaviour they find unsavoury risk hurting their investment returns - while not necessarily living up to ESG priorities. 

At a session on where investors should draw a line in the sand in their ESG responsibilities between financial returns and ethics at Clear Path Analysis’s Institutional ESG Investment Summit, Maria Nazarova-Doyle, head of pension investments at Scottish Widows, stressed that a distinction between ethical and ESG investments exists – although she acknowledged they overlapped in many areas.

Maria Nazarova-Doyle,
Scottish Widows

She cited tobacco assets as an example of an asset that often elicited dislike from investors for moral instead of ESG considerations.

“We regularly conduct large scale customer research in this area of ESG and ethical divestment to gauge views to capture trends and to be able to respond to their offerings,” she said.

The results, she explained, showed that those who smoked believed that tobacco investments should be included while those who did not wanted them removed.

Another example was a debate that arose over whether an ethical fund mandate under review should exclude investments from companies that test their products on animals.

"We couldn't agree whether animal testing is completely off-limits or whether it can be allowed for pharmaceutical purposes because of the Covid-19 pandemic,” she said.

Taking an exclusionary approach is the simplest means of ensuring the end-investors are not exposed to areas they dislike, but the approach lacks any nuance and can cause funds’ financial performance to suffer. While cordoning off some forms of company can act as risk mitigation, Nazarova-Doyle warned “the more you cut off, the more voluntary investment becomes an attempt not to perform so well”.


This philosophical argument might sound more fit for a student debating society than for a pension fund, but the investments returns are good for those that can get the model right.

Morningstar concluded that 35% of sustainable US funds placed in the top quartile of performers in 2019. And in Asia, ESG-related themes have increasingly become front of mind as a result of the Covid-19 pandemic.  

Tracy Wong-Harris, HK
Green Finance Association

Tracy Wong Harris, deputy secretary-general of The Hong Kong Green Finance Association, quoted in The Alternative Credit Council’s (ACC) recent report on private credit in Asia, said: “ESG investments consistently outperformed traditional investments during Covid-19 by 3%-4% across the globe.”

Today European funds and financial regulators are both typically further ahead than their Asia Pacific counterparts in their thinking about and implementation of ESG policies, but the concepts are likely to increasingly shape regional investors’ strategic plans as their awareness grows.  

Speaking at Clear Path Analysis’ conference, Rosie Rankin, director, clients department, Baillie Gifford, agreed that taking an exclusionary approach to investments is not necessarily one that works.

“You can get to the stage that you've excluded so many things that you've really narrowed down your investment universe,” she said.

Rosie Rankin, Baillie Gifford

Her answer is that pension funds should find a way of aligning making the world a better place while also fulfilling their fiduciary duty to provide their members with a healthy pension income.

She cited the example of prioritising investments into companies that are developing solutions to climate change.

“You want to find innovative battery companies that are able to store that energy and companies that are helping customers be more energy efficient. These innovations are helping us transition to a low carbon world, and [with] that innovation comes real investment opportunity,” she said.


The debate is more pointed for pension funds because of their long-term horizon, said Catherine Howarth, chief executive of responsible investment charity ShareAction.

“There are undoubtedly conflicts for individual stocks, but it's the task of fiduciaries in with diversified portfolios to take a more enlightened perspective to preserving the underlying systems that actually build our wealth and our well-being,” she added.

It is harder to have any kind of realistic ESG impact in the short term.

“If you're a short-term owner of shares, it's very difficult to have any influence and engage [with a company and its policies], because often the results of successful engagement, take years,” said Baillie Gifford’s Rankin.

Ashish Dafria, Aviva

The trick, said Ashish Dafria, chief investment officer of London-based insurer Aviva's UK life portfolio, was for the pension fund industry “to view ourselves as long-term owners and universal owners”.

That, he said helped to align that distinction or conflict between what is the risk now and what will be the risk in the future; what's purely ethical and what's financial.

The solution, he said, was for funds to acknowledge that not everyone has exactly the same risk appetite.

“We already offer lots of funds and lots of options, which are pitched at different risk appetite,” Dafria noted. “It's perfectly consistent to offer some very targeted impact funds which are specifically focused on one or two dimensions, and then have a broader philosophy of engagement which includes an integration in your broader portfolio.”

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