• Fund managers are facing greatly increased scrutiny with respect to their ESG practices, often in the form of detailed questionnaires
  • Providing boilerplate, check-the-box answers to due diligence questions is increasingly unacceptable
  • The need to make ESG disclosures is having the positive effect of causing asset managers to become more strategic and attentive to ESG integration
  • However, the lack of verifiable, standardized reporting (i.e. a GIPS equivalent for ESG) means the disclosure environment remains a “Wild West” of information that can be self-serving and difficult to interpret
  • Self-reported information cannot be taken at face value and is vulnerable to exaggeration, omissions and cherry-picking
  • Carefully-designed questionnaires can improve the reliability and objectivity of the information collected
  • Empirically’s approach to ESG evaluation avoids the issues with questionnaires by relying solely on a Portfolio Manager’s actual buy and sell decisions
Fund Manager Answers ESG Questionnaire

Fund managers will naturally tend to answer due diligence questions in the way that casts them in the most favorable light.

Questions About Questions

Suppose that a prominent university begins to receive an increasing number of questions from stakeholders regarding its financial investments, and to what extent they are ethical and aligned with the institution’s mission and values.  Further suppose that its oversight body, such as the board of trustees, decides to undertake a review its ESG investing credentials. To get the ball rolling, it sends a detailed questionnaire to the CIO and investment committee of its endowment or pension plan.

To gather the required information, the CIO and her team then send questionnaires to all of their external managers. To help answer those questions, the external managers subscribe to ESG data providers, and also write their own questionnaires to send to all of their holdings. To assemble ESG data sets, the data providers then send questionnaires to all of the firms that they wish to rank and rate.

(And for good measure, to rate the ESG raters, ESG rater raters also send questionnaires to rating providers.)

Multiply this chain of events across thousands of asset owners, and corporate investor relations departments suddenly face an avalanche of inbound questionnaires – some of them requiring dozens of pages of detailed responses, and requesting data about issues they have not been tracking and may not have even heard of.

While a Head of IR is well-versed in discussing EBITDA margins and R&D priorities, she may be stumped by questions such as:

  • Provide the emissions from biogenic carbon relevant to your organization in metric tons CO2.
  • Describe your gross global combined Scope 1 and 2 emissions for the previous year in metric tons CO2e per unit currency total revenue and provide any additional intensity metrics that are appropriate to your business operations.
  • Provide details of key waste streams generated and how these are managed/disposed of, including any particular waste management initiatives that have been implemented to minimize or reuse/recycle wastes. In your response, please provide tonnages (if available) and confirm the method of data collection.

She then has the option to decline response, or seek to get the questions answered. This entails enlisting corporate communications and business line resources, and – increasingly – dedicated CSR teams and external consultants.

All of this filters back up the chain, with each level answering their own questions regarding how data from the previous levels are acted upon. For example, managers are posed questions such as:

  • Is your firm a signatory to the UN Principles for Responsible Investment (PRI)? If not, why not?
  • Is there anything proprietary about your ESG approach or data sources?
  • Please provide three specific examples of how your firm has engaged on ESG issues with a company in which you invest. For each example, describe the engagement process, the outcome, any related trading activity, and any follow-ups or monitoring.

Questionnaires have become so prevalent because unlike the Global Investment Performance Standards (GIPS), which provide a commonly recognized assessment framework that can be audited and verified, there is no easy way of measuring the success of an ESG integration effort. How should the non-financial impact of a portfolio be communicated and tracked over time? How can we attribute Portfolio Manager decisions to ESG outcomes in an objective way? The answers to these questions are still at least several years off, given both the lack of high-quality data at the corporate level, the large number of distinct issues under the ESG umbrella, and differences in perspective about the value and salience of each issue.

A tremendous volume of ESG disclosures is now being produced at all levels, much of which is qualitative or in textual format. These can be harnessed to positive effect in several ways, discussed in the next section, but also have important caveats (following section).


The Positive Effects of ESG Questionnaires

Perhaps the most important impact of the rise of ESG-related due diligence has been to force companies and asset managers to devote more thought and effort to the underlying issues. Nowadays, it is becoming increasingly untenable to simply have a public relations department publish boilerplate sustainability language, as investors become increasingly detailed and demanding in their scrutiny of ESG practices.

The need to provide answers to stakeholders is encouraging company executives and fund managers to form a true strategy on a range of ESG issues, and track their progress over time. This naturally results in better outcomes than untracked, unmanaged efforts.

Another major advantage of ESG questionnaires is that they receive answers in writing. This improves reliability and trustworthiness versus informal interviews, since respondents can more easily be held to account for the disclosures they provide.

Structured, uniform questions also facilitate comparison across firms. For example, the level of detail and thoughtfulness that an asset manager devotes to a response can provide insight into how seriously that topic is taken by the organization.

Overcoming the Limitations of Questionnaires in Manager Due Diligence

Despite their positive effects in encouraging greater focus on the underlying issues, questionnaires can be a precarious basis on which to make manager selection decisions. Rather than taking the responses at face value, investors should form their assessment with the following key issues in mind.

Selective Disclosure and Non-Verifiability

Respondents can have latitude in how they answer questions, and sometimes in whether they choose to respond to a questionnaire at all. The downside of self-reported information, which fund selectors have no way of independently verifying, is that fund managers will naturally answer questions in a way that casts them in the most positive light.

This could include exaggerating the emphasis placed on particular issues or the depth of a diligence process, cherry-picking or omitting case studies, or “rewriting history” by attributing alternate rationales for decisions that did not actually exist at the time.

To combat this issue, phrase questions as specifically as possible, defining any potentially ambiguous terms and limiting the scope for interpreting the question in multiple ways. Case study questions (“describe an example of how…”) can provide insight into a manager’s approach, but it should be noted that the cases chosen may not be representative or typical of the investment process.

Heterogeneity Within an Asset Management Organization

ESG questionnaires are often answered at the firm level as opposed to the product level. Even product-specific RFPs may simply duplicate firmwide language with respect to topics such as engagement, proxy voting and incorporating ESG issues. This masks what can be considerable variation in how individual Portfolio Managers implement the same policies.

Therefore, it’s critical to find out who exactly the respondent is who has prepared the answers to the questionnaire. If the respondent is divorced from the investment team – such as a marketing, compliance, risk, or dedicated ESG professional – then further investigation is needed to determine how representative the answers are of the actual process being employed in the product under consideration.

Check-the-Box Metrics

Partially in response to the issues with evaluating the substance of manager disclosures, fund investors sometimes use binary ratings in manager scorecards, such as:

  • Is a formal ESG integration policy in place? [Yes/No]
  • If an external proxy voting advisor is used, is there a procedure for overriding the policy recommendations? [Yes/No]

Metrics like these have limited utility today. A few years ago, they might have been indicators of a forward-looking and thoughtful investment firm, but soon 100% of managers will answer them all in the affirmative – giving them no comparative value. Additionally, having a policy means very little. It’s not infrequent to observe very large asset managers with a formal ESG policy only 1-2 pages in length, comprised largely of generalities.

Instead, asset owners should focus on trying to come up with quantitative measures that are similarly unambiguous, but provide more valuable information than check-the-box metrics. For example, a question about the number of staff members dedicated full-time to ESG research and engagement provides much more detail about the manager’s degree of focus on these issues.

Actions vs. Words

Given the abundance of ESG-related greenwashing, it’s easy to be cynical about whether ESG disclosures are reliable indicators of a firm’s true values and practices.

When a mining company with top-rated ESG credentials blows up a 46,000-year-old indigenous heritage site to make way for an iron ore mine, it calls into question whether investors are placing too much weight on firms’ “image management” PR efforts.

Greenwashing and ESG disclosures

British Petroleum’s 2000 ad campaign, trumpeting its name change to “Beyond Petroleum”. In 2019, 99% of the company’s revenues and 96% of capital expenditures were attributable to conventional energy.

While high-profile examples of greenwashing are often exposed at the corporate level, asset owners should be aware that fund managers can be guilty of it as well.

Given how difficult it is to determine how representative a Portfolio Manager’s responses to an ESG questionnaire are of her true investment process, Empirically has developed an approach to ESG evaluation which relies solely on actual buy and sell behavior. Our view is that the most objective external measure of a manager’s beliefs is what she actually chooses to own – and not to own – in her portfolio.

By quantitatively analyzing a strategy’s historical holdings in conjunction with our proprietary data – including a library of ESG factors, the holdings and returns of other ESG-focused and non-ESG-focused funds, and a data set of notable ESG controversies – we can obtain the following information:

  • An objective categorization of the ESG approach actually being practiced by the Portfolio Manager (i.e. exclusionary, best-in-class, contrarian, agnostic)
  • The strategy’s propensity to own firms which subsequently become embroiled in high-profile controversies, relative to peers and its benchmark
  • A breakdown of the exposure to different sets of ESG issues
  • A quantification of the impact of the ESG orientation on investment performance

We believe that this data-driven approach is an ideal complement to carefully-developed questionnaires to develop a full picture of an asset manager’s approach to the complex landscape of environmental, social and governance issues.

Author Information: Jordan Boslego is a Partner at Empirically.

Updated September 2020.