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What does the Rise of ESG Mean for Asset Managers' Operations?

Whether managers are working with ESG-focused investors or launching their own ESG products, they should consider the challenges to their front-, middle- and back-office operations.

The asset management industry’s embrace of environmental, social and governance (ESG) investment principles has played out as a slow burn over the course of the past decade. Now, awareness of the movement and the will to implement socially responsible investing practices has picked up for asset managers. 

Industry value systems are transforming through changes in investor demographics, social justice issues, and climate change as conversations around these topics have grown louder, followed by increased acceptance of ESG investment strategies.  

Investors have served as a key force in managers’ adoption of ESG principles. Eighty-five percent of hedge fund managers say that institutional investors are the biggest drivers of demand for ESG-oriented funds, and the percentage of institutional investors that implement ESG approaches rose by 18% from 2019 to 2021.1, 2 Industry embrace is also boosted by the performance of some ESG-based ETFs. For example, the Northern U.S. Quality ESG Fund (NUESX) has outperformed the S&P 500 within the last year (37.59% vs. 35.22% as of July 14, 2021). 

But as funds respond to the ESG wave by launching specific products, recruiting for sustainable investing leadership, and defining their own policies for how their firms commit to a socially responsible approach, they will want to consider the impact on their operations, from front to back office.

Operational challenges

The reality is that ESG’s growing influence over the industry will bring new operational requirements for fund managers. Many managers are proactively driving change, but those who are taking a ‘wait-and-see’ approach will eventually be moved to act through pressure from investors and regulators. 

As ESG’s influence continues to move into the asset management space, managers will have to prepare for how ESG considerations will affect the operations across the whole office. Front office teams will have to ensure that their investment screening and portfolio construction decisions align to their ESG strategies or investor mandates, while compliance and regulatory teams in the middle and back office provide a review function for adherence to mandates and regulations. Managers should also explore opportunities to partner with their fund administrators given much of the data integration with their investment and accounting books of record exists on their platforms.  

In addition to examining the changes encountered across the whole office, asset managers should consider the new operational challenges they will face from three key perspectives:

  • Working with investors with their own ESG policies

While regulations exist in certain jurisdictions, ESG mandates are still primarily driven by institutional investors. Lack of standardization provides an operational burden on fund managers thanks to additional due diligence requests and customized reporting for prospective investors.  

Fulfilling custom reporting requests will require screening and contracting with an ESG data vendor or utilizing market data through their administrator’s vendor relationships. Depending on the manager’s strategy and product scope, ESG data from multiple providers may be needed to provide broad coverage across the entire portfolio (i.e., public market vs. privates/alternatives). 

Managers may find an influx of these requests coming from pension fund investors first as they increasingly are regulated by their regional or federal governments to have ESG statements attached to their portfolios and proof of how their investing practices adhere to their responsible investing philosophies. Ontario, Canada; South Korea; the EU; and the UK all have ESG regulations specifically targeted at pension funds.3, 4, 5, 6

  • Defining and adhering to an ESG policy as a manager

As fund managers begin to set their own ESG policies and/or offer ESG products, managers must consider their overall ESG investment strategy (activist vs. passive ownership) and implement policies to support that chosen strategy. These policies may cover active engagement with investee companies on ESG issues, proxy voting on related resolutions, or short selling and divestment of poor ESG performers.

They will also face a new set of reporting requirements, proving to investors that their products comply with their portfolio mandate and regulatory requirements. With sprawling and complex portfolios, managers may be challenged in validating how their investment decisions live up to their firm’s ESG policy and supporting them with independently sourced data and metrics from external vendors.    

Many managers are viewing ESG monitoring as an extension of their compliance service, ensuring that their portfolio composition meets ESG objectives and is reflected accurately across regulatory reporting and investor marketing materials. Leveraging their compliance function minimizes the manager’s risk of not detecting portfolio investments outside of their ESG policies. This requires data to be accessible in various steps of the investment lifecycle:

  • Pre-trade analytics: Does the firm have the necessary metrics and data to incorporate in the portfolio construction process? 
  • Investment execution:Will the execution of a trade impact portfolio management from the perspective of its ESG mandated strategy? 
  • Risk management:How does a firm incorporate responsible investment metrics as part of its risk management practices? 
  • Post-trade compliance:Does the firm have subject matter experts that are well-versed in ESG regulations? Who will provide oversight or systematically introduce governance across the various firm operations? 
  • Regulatory reporting: Who will ensure adherence to evolving regulatory requirements?
  • Investor marketing materials: Do the fund’s marketing materials as it relates to ESG investment objectives align to the actual management of the portfolio? 

Determining how to leverage technology to integrate ESG vendor data with upstream sources (such as transactional, positional, and security master data) and make it available across the whole office could provide its own set of challenges. If managers begin to define their own ESG policies, regulators in various regions may ask them to report on how their strategies adhere to their policies in order to prevent greenwashing – when firms communicate sustainable values from a marketing perspective but fail to execute and live up to their claims in practice.

  • Complying with a patchwork of global ESG regulations

Emphasis on ESG investing is picking up globally, and regulatory bodies are either already mandating how asset managers meet and disclose ESG objectives or are determining how they should bring forth regulations. For funds that decide to set an ESG policy and offer responsible investment products, they must determine the regulatory requirements for each region and legal jurisdiction in which they operate, as there is not yet alignment on global standards. 

The U.S. remains without any kind of federal ESG regulations targeted at asset managers or asset owners, but the SEC has deemed it a focus for the near-term with a recent request in March for public comment on inclusion of climate risks in issuer disclosures. In addition, as of June 16, 2021 the U.S. House of Representatives passed the Climate Risk Disclosure Act which requires companies to disclose their impacts to climate change. Any issuer of a security will be required to disclose information regarding climate change risks, including their efforts to mitigate those risks. The act also requires the SEC to establish industry-specific climate standards.7 While this bill faces headwinds in passing the U.S. Senate and becoming law, this is just one example of the increased legislative efforts to implement formal regulation on climate risk and other ESG topics.  

In the European Union – widely considered the global ESG leader thanks to its growing regulatory framework – fund managers will face two recently implemented regulations aimed at ESG measures, or lack thereof. One is the EU Taxonomy Regulation, coming into force in January 2022. The regulation provides a framework to identify to what degree asset managers’ financial products are living up to environmentally sustainable values based on a series of six objectives. It applies to all financial products which set an environmental sustainability objective or promote environmental characteristics.  The other major EU regulation applied to asset managers is the Sustainable Financial Disclosure Regulation (SFDR), which aims to combat the potential for greenwashing by putting additional transparency stipulations on asset managers, requiring them to report on how they make sustainable investments.8 If managers do not take environmental sustainability into account with their funds, they must make a statement acknowledging this. 

In APAC, most existing regulations target institutional investors as opposed to asset managers, but Singapore’s Environmental Risk Management Guidelines require asset managers to disclose environmental risks within their portfolios.9

Outside of legal requirements, several examples of global governing body and industry group attempts to promote standardization exist today.  

  • Principles for Responsible Investment (PRI), a sponsored entity of the United Nations, is releasing their report, A Legal Framework for Impact, this summer. The report is aimed at aligning the investment sector with managing sustainability impact.10
  • The Sustainability Accounting Standards Board (SASB) has published recommended ESG metrics by industry.11
  • Large managers, such as BlackRock, and over 1,000 global organizations now formally support adoption of the disclosures and recommendations from the Task Force on Climate-Related Financial Disclosures (TCFD). As of February 2020, 473 financial firms responsible for $138.8 trillion in assets were supporters.12

As more regulations emerge, fund managers will likely need assistance staying on top of how their funds are required to operate depending on where they are domiciled and who their investors are. 

 

The combination of these three perspectives -- investors’ ESG focuses, managers’ ESG focuses, and regulatory guidelines -- may have major impacts on a fund manager’s operations that will be challenging to tackle alone. Managers will want to explore how their fund administrator is equipped to support their transition into this new era of socially responsible investing. Fund administrators can ease the operational transition for integration as the provider of the manager’s books of record, through their data management capabilities and integration with ESG market data vendors, and through their expertise of industry regulations. 

The pressure to offer ESG-focused investments will continue its influence and should be seen as a new opportunity to appeal to investors’ growing concern for responsible investing. An emphasis on ESG investing may be in early stages in most regions of the world, but its impact will only advance as governments and society place more importance on managing climate risk and socially equitable business practices. 

As the ESG outlook takes a stronger hold in the industry, the expectations and regulations placed upon fund managers become more complex. While the shifting landscape of investor demands and regulatory requirements presents new challenges to all facets of a fund manager’s operations, those who proactively integrate ESG practices into their business stand to benefit from the increasing interest in sustainable investing among large institutional investors.   

By partnering with their fund administrator, managers can leverage their administrator’s experience to help mitigate the operational impacts across the whole office. 

 


1 KPMG, Sustainable investing: fast-forwarding its evolution”, 2020.
2 Natixis, “ESG Investing: Everyone’s on the bandwagon”, 2021.
3 Pensions & Investments, “Ontario requiring all DB funds to disclose ESG data”, January 9, 2015.
4 Green Finance Platform, “National Pension Fund Investments to Include ESG Considerations (National Pension Service Act, Chapter VI Article 102 (4))”.
5 Pensions Europe, “IORP II Directive”.
6 Latham & Watkins LLP, “ESG Factors Spur Changes in UK Pension Scheme Disclosure Requirements”, August 21 2019.
7 U.S. Congress, “H.R.2570 - Climate Risk Disclosure Act of 2021”.
8 Bloomberg, “Demystifying the Sustainable Finance Disclosure Regulation”, February 5 2021.
9 Mayer Brown, “Singapore Regulator Issues Environmental Risk Management Guidelines for Asset Managers and Other Financial Institutions”, December 16 2020.
10 PRI, “A Legal Framework for Impact”.
11 SASB, “SASB Standards & Other ESG Frameworks”.
12 TCFD, “More than 1,000 Global Organizations Declare Support for the Task Force on Climate-related Financial Disclosures and its Recommendations”, February 12 2020.

Nadia Cobalovic

Co-Chief Operating Officer, Northern Trust Hedge Fund Services

David Mina

Head of Client Service, Portfolio Analytics and Risk

Mike Mullen

Head of Platform Management, Portfolio Analytics & Risk

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