How to construct your fund's SRI strategy

They need to do so while fulfilling their fiduciary duty to deliver the best performance to their plan members. Pension funds have unique features meaning they need to be able to meet both short-term and long-term obligations.

Many schemes have members to whom they will need to make payments 50 years from now. While their fiduciary duty urges them to provide the best possible return, including over the shorter term, they cannot do so while jeopardising the opportunity to generate sustainable long-term returns.

They also need to take into account the effect their investments will have on their members’ future quality of life.

They will therefore need to integrate environmental, social and governance research and opinions when making investment decisions, both in terms of opportunities and risks. This is possible across all asset classes.

Investing in infrastructure means investing in the real economy and it provides a platform for economic growth and comfort for society. Transportation and energy infrastructure are natural choices.

For SRI investors, there are great opportunities linked to the rollout of the smart grid, building renewable energy generation capacity and creating a network of charging points for electric vehicles.

The financial crisis has painfully resulted in a situation where most governments do not have sufficient means to invest in the infrastructure needed to support the evolution of our society.

They will therefore increasingly turn to the private sector to look for co-investment. Public-private partnerships funding schools, hospitals and large-scale leisure facilities will become more commonly used and provide excellent opportunities for SRI investors. From an investor point of view, infrastructure delivers regular, stable returns that are uncorrelated with the equity market.

Managing your environmental risk

Traditionally, SRI bond investments focus on risk management. More specifically, SRI bond investors typically aim at avoiding high environmental, social and governance risks for both government and corporate bond portfolios, making the assumption that a better environmental risk management, for example, will ultimately lead to lower default risk.

Apart from focusing on avoiding ESG risks, more positive options are offered in the form of green bonds and social bonds. The proceeds of those bonds are used to finance specific projects with a positive environmental or social impact. The recent climate bonds issued by the European Investment Bank are one example.

More recently, innovations in the bond market are widening the scope for SRI and impact investors, linking return to predefined environmental or social impact characteristics.

Within listed equities, investors have applied different approaches. Traditionally the focus has been on exclusion, mainly based on ethical criteria and on using a best-in-class approach, investing in those companies that offer the best ESG track record within their industry.

As this selection is not driven by financial motives, this approach is sometimes criticised as being difficult to combine with the fiduciary duties of a pension fund.

Incorporating ESG factors

An approach that integrates ESG data into financial decision-making is winning in popularity. This method is typically more thematic, more long-term oriented and less benchmark-driven.

It starts with the recognition that the world is constantly evolving and companies that will prove to be the ultimate winners are those that will facilitate that evolution. Some of those long-term trends are demographic in nature, such as population growth and ageing populations.

Others are more social and economic, such as urbanisation or the evolution of emerging market consumption; environmental, such as climate change or depletion of natural resources; or driven by technological innovation.

SRI funds focusing on ESG integration will therefore find opportunities in water treatment, education, technological changes, sustainable finance, health, and so on.

While the main objective of this approach is generating return, risk management is also critical – including this can also have an important financial impact on the share price.

To facilitate this, pension funds should consider changing the risk-return framework from a specific benchmark approach over a short-term period to an absolute approach over the long term.

Actively engaging with the management of the companies they invest in can help organisations become better citizens and will ultimately lead to better investments.

Jens Peers is chief investment officer, sustainable equity, at Mirova, a division of Natixis Asset Management