What the FCA’s SDR proposals mean for portfolio managers in practice

Pinsent Masons has teamed up with Neill Blanks, managing director and head of funds research at sustainable investment specialists MainStreet Partners, to consider what the regulator’s proposals, which are currently open to consultation, mean for providers of portfolio management services.

Practical implications

Portfolio managers will need to consider their approach to investing in funds within the SDR rules. Treating funds as ‘assets’ raises some practical issues. Additionally, extra care will be required when selecting KPIs and setting out stewardship and escalation plans – this is because investing in external funds reduces the level of control over the management process and portfolio managers remain responsible for ensuring ongoing compliance with general and label-specific criteria.

Due diligence

The FCA has stated that a sustainability label is not itself an absolute measure of sustainability and therefore portfolio managers will need to carry out due diligence on external funds.

In this respect, Blanks said, it is important to differentiate between traditional fund manager due diligence, which focuses on financial considerations, and sustainability due diligence, since the latter requires additional qualitative analysis given the lack of numerical information and benchmarks.

Nonetheless, he said there are good practices to learn from in respect of traditional due diligence that can be carried across to sustainability.

Blanks said: “Many firms undertake both ‘investment due diligence’ and ‘operational due diligence’ to get a full 360-degree view of an external fund. Sustainability due diligence should also seek that well-rounded assessment.”

“Therefore, good sustainability due diligence isn’t just about understanding a fund’s sustainability objectives but also requires assessment of what resources and capabilities are required to deliver that objective and what parts of the business contribute to that success – something that is reflected in the FCA’s consultation paper when it extends the ‘resources, governance and organisational arrangements’ requirements to external funds,” he said.

Managing risks to effective due diligence

There are additional regulatory requirements which constrain the due diligence process. This raises issues like how providers can manage the risk that an external manager may invest in assets which conflict with your portfolio’s sustainability objective.

Blanks said that it is imperative to understand the inputs to a manager’s investment process and what drives sustainability-related decisions, given there is “no golden source of truth for sustainability”. He said only then can providers assess the alignment of their strategy with their sustainability objectives and evaluate the risk of conflicting investments.

“At MainStreet, we look at three different layers to assess how robust a strategy is,” Blanks said.

“First, we look at the firm’s commitment to sustainability and their track record in delivering sustainable products. We also consider whether incentives are aligned, such as whether sustainability is integrated into remuneration practices. This provides a view on the manager’s institutional credibility to deliver the strategy,” he said.

“Secondly, we assess the strategy itself, the team delivering it and their investment decision-making process. This is designed to reveal weaknesses in the controls environment which might otherwise ensure delivery consistent with the stated strategy. For example, some managers may source ESG data from different vendors to cross-check and validate sustainability assessments. An asset manager relying solely on one third party view will adopt methodological limitations or biases and may not identify data anomalies or inconsistencies. Additionally, some managers may implement risk controls to prevent portfolio managers from overriding sustainability assessments. Analysis could also look at the strategy and whether it focuses more on screening out or screening in investments,” he added.

“Thirdly, we also assess the current holdings of the external fund to identify any discrepancy between the stated strategy and what is being invested in. At MainStreet Partners, we have various analytical models to score portfolios on their ESG profile or alignment to the UN Sustainable Development Goals (SDGs) to provide a quantitative check against the qualitative assessment of the strategy. The identification of investments in a portfolio with previous involvement in sustainability-related controversies or low ESG scores suggesting weak ESG risk management would be a marker for higher risk of investing in conflicting assets,” Blanks said.

“So good sustainability due diligence will identify these data-related, operational and investment-related controls to build up a picture of how robust the external manager’s strategy is and then compare the existing portfolio against that understanding,” he concluded.

Setting KPIs under the SDR regime

When investing in external funds, a manager has less control over the achievement of KPIs selected to demonstrate progress towards the sustainability objective. Therefore, as we highlighted previously, extra care needs to be paid by portfolio managers investing in external funds when selecting KPIs so as not to jeopardise use of the sustainability label or to trigger escalation plans in the event external funds do not demonstrate adequate progress.

The FCA has left open the option to select KPIs at the portfolio level or individual fund level.

Blanks said MainStreet Partners can calculate sustainability KPIs on an external fund prior to investment in it based on the quantitative portfolio models it has developed. This means it does not need to wait for fund managers to report on their KPIs in their periodic disclosures. Despite this, he said there are challenges to navigate with analysing the KPIs that funds report against.

“Our experience is that there is significant ‘noise’ in these KPIs as they are predominantly an output of the investment process rather than KPIs which the funds are actively managed against,” Blanks said. “This is important because it reveals that portfolio managers should only be setting KPIs which they are integrating into the investment process. Otherwise, they are very likely to report KPIs which may not reflect progress towards the sustainability objective.”

“This issue has recently received more attention as managers seek to increase their exposure to ‘transition investments’, which may in the long run lead to decarbonisation in high climate impact sectors, but which come at the short-term cost of higher reported carbon emissions metrics,” he said.

“Therefore, particular care should be taken when selecting KPIs and how they support the measurability of the sustainability objective. Portfolio managers looking for guidance could consider the UK Transition Plan Taskforce’s sector guidance for asset managers, which illustrates different types of metrics,” Blanks added.