How institutional investors can make a social impact in portfolios

The momentum around net zero investing has helped focus the minds of institutional investors on ways to tackle climate change and how to respond to the changing policy landscape. This has led to fundamental change in how pension funds and insurers view their portfolios over the longer term – leading to the steady integration of environmental risks and opportunities.

It is perhaps understandable that social factors – the S in ESG – have appeared to take a back seat as a result of this carbon ‘tunnel vision’.¹ Their dispersed nature contrasts with the linear clarity of the net zero narrative. However, these social factors lie at the heart of corporate strategy and can potentially give clues to future corporate fragilities. For any investor seeking to protect against downgrades or defaults – and looking to support a more sustainable economy over the longer term – it may be time to discover how they could be successfully integrated. At AXA IM, we see a spectrum of implementation possibilities for institutional investors who want to take an active view around social investing.

The first option is to focus on the potential financial benefits of making sure the ‘S’ forms an important part of the ESG analysis carried out by your asset manager. Social factors such as supply chain management, human capital policies and discrimination can have direct and immediate effects on company valuations, and we think there are clear advantages in addressing such material risks as investors seek to improve risk-adjusted returns. In fixed income, this is about avoiding defaults and downgrades – in equities it can be about improving alpha, or excess returns. To do it, investors might set exclusions criteria or tilt portfolios to issuers with better performance on social factors, as well as supporting active engagement that encourages businesses towards more sustainable practices.

To take a step up in the social spectrum, investors may wish to apply a ‘do no significant harm’ principle to portfolios, involving the removal of issuers associated with the worst negative impacts from social factors. This would be from a purely non-financial perspective, although we would expect a risk mitigation effect and a close correlation with tail-risk ESG scores which we believe can be aligned with more resilient financial performance. This principle is gaining traction with regulators and forms a key pillar of the EU Taxonomy – new European rules designed to define the activities companies can claim are climate-friendly.

A further enhancement of social integration in portfolios can be delivered through the pursuit of a measurable positive social contribution. This may involve favouring issuers with best-in-class social practices around things like gender diversity at board level or workplace accidents, even if a company is not directly involved in socially progressive business activity. Investment philosophy will play a role here: Do you believe companies that make a good social contribution will hold less risk over the longer term?

The fourth and final stage of the social investing spectrum moves into the realm of pure ‘impact’. At this point investors can consider social and sustainability bonds as well as companies where the social impact is deliberate, genuine and measurable. It also opens up the possibility of detailed key performance indicators (KPIs) that offer alignment with the Sustainable Development Goals (SDGs), the United Nations targets that are helping set the direction and drive the momentum for countries and investors alike.

Overcoming challenges

To integrate social factors in portfolios, whichever approach is favoured, we need appropriate metrics. In this social space, that throws up some intriguing challenges, compared to our now familiar climate-related metrics:

• Uniformity: The S in ESG is a many-headed beast. Everything related to staff, suppliers, consumers and other stakeholders contains a social element, as do many of the factors primarily considered as environmental concerns. The dispersed nature of social factors risks blurring the focus or forcing compromises between them. Contrast this with the single and specific goal of achieving net zero by 2050 and the uneven approach to social investing is unsurprising
• Unity: Whereas climate and net zero enjoy a relatively strong consensus between governments, investors and consumers, the picture around social is less joined up. Investors are steadily getting there, and many consumers are already thoroughly engaged, but we believe policy and regulation often struggle to properly address the many and varied fragilities at play in social – partly due to the lack of uniformity described above, and partly due to the political challenges involved
• Urgency: Climate change is now understood as a clear and present danger. The timeframe has been established and the need for action aligned with that goal. Social effects, however, could take longer to emerge and be attributed to multiple factors. Some effects will be immediate, but may be related to an individual issuer, such as in the handling of human capital.

So how can investors address these challenges? We think the 17 SDGs offer a genuinely powerful framework that helps to overcome the issue of uniformity – it can be argued that most of them relate to social considerations directly or indirectly, often in combination with the environment. Their breadth of coverage and universality are precisely what is required if an investor wants to reshape a portfolio with the goal of either mitigating against social risks, or directly contributing to social good.

Scoring remains a combination of the qualitative with the quantitative – an inexact science – but we have seen that most issuers can be scored against most of the SDGs using third-party data and our own research. That delivers a scoring system that runs from +10 to -10 to cover both risk-mitigation from potential significant harm and verifiable positive impact. A lot of issuers fall somewhere in the middle but importantly, standout problems can be identified, and it is becoming clear over time that regulatory requirements (e.g. the EU Taxonomy) may be mapped across the SDGs. We do recognise that these are a starting point in the social investing journey and the market will likely evolve over time – as in the case of climate investing.

Putting it to work in portfolios

As an illustration of how using the SDG framework could work in practice, we looked at the impact in the investable universe when excluding the worst offenders – and identifying any potential effect on financial results. Where that line is drawn is down to the individual investor, but in our sample analysis, we used the sterling non-gilts index and excluded any issuer with an overall SDG score of below -5.² We would consider this an appropriate ‘do no significant harm’ policy.