A recent report by Watson Wyatt suggests that pension fund managers may be able to meet their fiduciary duty and benefit from engagement with companies on environmental, social and corporate governance (ESG) issues if they opt for sustainable investment strategies.

The report ‘What is Sustainable Investment?' says sustainable investment aims to improve the financial performance of a mainstream portfolio. A sustainable investment style uses financial measures to exploit issues and identify potential investment opportunities, unlike ethical investment, which, according to Watson Wyatt, deems certain companies and sectors unsuitable for investment through negative screening. The report places SRI within the bounds of ethical and sustainable investment due to its practice of negative and positive screening as well as its extra-financial considerations.

Watson Wyatt says that trustees' fiduciary duty to deliver the best possible investment return for members excludes the use of ethical or even SRI investment by pension schemes - with the exception of fund options within a DC scheme - but that the use of sustainable investment based on financial reasoning is appropriate.

Perhaps predictably, specialists do not all agree with Watson Wyatt. Pictet asset management's sustainability expert Christoph Butz does not think a debate on words helps: "Whether to use the terms ethical investment, responsible investment, socially responsible investment or sustainable investment does not matter, and the definitions used are Watson Wyatt's view. The wording and the concepts have certainly evolved over time, but for all practical purposes they can be used interchangeably. I really see no point in introducing every now and then a new definition for the same thing. The term ESG was already a make-believe invention because SRI integrated environmental, social and governance aspects long before the term was coined."

Matt Christensen, executive director at the European Social Investment Forum (Eurosif), says: " We have a different approach to Watson Wyatt because we meet pension funds that will in one portfolio negatively screen out one industry and then engage in all the others. Most Dutch pension funds, for example, screen out weapons and still achieve good returns. It is an approach that encompasses a mix of screening as well as engagement, which we call broad SRI."

Eurosif differentiates between broad and core SRI. The latter is based on ethical exclusions, positive screens including best in class as well as pioneer screening. Broad SRI is about engagement and integration but also contains widely accepted exclusions such as weapons, tobacco and human rights abuses, which, according to Christensen, most pension funds do not want in their portfolios. It can also contain screening according to multi-lateral norms such as the ones set by the International Labour Organisation.

Watson Wyatt suggests active fund managers examine ESG in order to construct portfolios with superior long-term risk and reward profiles. It argues that firms engaging in sustainable investment and
recognising a wide range of ESG issues could see long-term investment potential improve because it may be possible more readily to establish the effects of companies' ethical activities.

Christensen says: "I believe the mainstream will more quickly adopt integration and engagement strategies; more money is already flowing into that area. If you screen out tobacco or nuclear weapons in a capital market like the US, you can argue that it will not impact on trustees' fiduciary duty because they have a large enough market to choose from. However, in a market such as France, this could impact on performance."

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