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An LDI approach to ESG

30 Jun 2015

IN A NUTSHELL

  • The integration of environmental, social and governance (ESG) factors into an investment process ensures sustainability over the long term.
  • This is no longer a theoretical concept and can be applied to investment analysis.
  • Embedding an ESG framework into the investment process gives investors the best chance of meeting their future liabilities.

A liability-driven investment (LDI) approach is when an investor’s liabilities drive their investment strategy, an approach we believe that all investors should adopt. How this approach is applied depends on the specific investor’s financial position and behavioural factors.

For example, a risk-seeking individual with wealth way in excess of their living requirements will have a very different LDI strategy to a retirement fund that is straining to meet its inflation-adjusted obligations to its pensioners.

It is important to note that in some cases, such as defined benefit funds, liabilities can be very long term in nature, and it is not uncommon to see liability obligations that extend in excess of 100 years. These investors need to take a very long-term view when developing an LDI investment strategy.

Long-termism

If an investment manager truly takes a long-term view, it implies that they have applied an environmental, social and governance (ESG) lens to their investment analysis, because these factors have a material impact on the sustainability of the investment and therefore on the investor’s liabilities. If, for example, our generation chooses to ignore ESG considerations, then future growth rates can be expected to be lower. The same would apply to future discount rates (i.e. the rates that we use to determine the value of future liabilities in today’s monetary terms). This would result in liability values increasing in the future. If future growth rates are lower, this, in turn, would decrease the likelihood of being able to find suitable investments that will grow over time to meet the projected liabilities. Incorporating ESG considerations into the investment process is therefore critical.

Applying the theory

While ESG reporting and analysis is in its relative infancy and much work is required to encourage greater transparency and consistency of reporting, a significant amount of progress has been made. It is also no longer a theoretical concept and can, and should, be applied to investment analysis.

Here is an example of how an ESG framework has been applied to the South African (SA) telecommunications sector. The table reflects a sample of ESG risk factors and their influence on creditworthiness and the subsequent impact on the pricing of bonds that may be held in an LDI portfolio, together with our respective views. Embedding an ESG framework into the investment process becomes a “must” in terms of ensuring a sustainable investment strategy. This will serve to give investors the best chance of meeting their future liabilities.

Telecommunications ESG analysis using MSCI risk and opportunity factors
table-23

  • Trevor Abromowitz
  • Tanja Tippett
  • Liability Driven Investments