Asset owners should abandon traditional approaches to evaluating investment manager performance in favour of a scorecard approach that encompasses net zero targets, the CFA Institute has said.
As the importance of finance in achieving the green transition is emphasised at this year’s Climate Summit in Azerbaijan, the CFA Institute has released a report encouraging investors to better incorporate net zero goals into investment strategies.
The report Net-Zero Investing: Solutions for Benchmarks, Incentives, and Time Horizons argues that traditional performance evaluation practices “with the narrow focus of evaluating portfolio returns relative to a market index over short time horizons” present barriers to net zero investing.
Instead, investors should, according to Chris Fidler, Head of Global Industry Standards at CFA Institute, “look to adapt their strategies to meet both climate and financial objectives”.
He says: “Our research shows that managing the transitions [to net zero] requires more than just setting long-term climate targets. It involves integrating net-zero benchmarks, aligning incentives, and adopting suitable time horizons for meaningful progress. Without these changes, asset owners risk missing out on opportunities while failing to mitigate long-term systemic risks.”
The CFA Institute reports that for a net zero program to be fully effective, objectives and targets should be set for short-, medium-, and long-term periods. For example, to achieve net zero by 2050, the Net Zero Asset Owners Alliance (NZAOA) recommends absolute emissions reduction targets of 22 per cent to 32 per cent by 2025 and 49 per cent to 65 per cent by 2030.
The Institute says a net zero benchmark or scorecard should “fairly represent the asset owner’s net zero objectives and serve as a point of reference against which manager efforts are assessed”.
However, at present most managers are assessed and rewarded based on financial return rather than contribution to meeting net zero targets.
Fidler says: “Active managers who are incentivised under current conventions may not pursue investment actions that contribute to the net-zero goal, and they may even take actions that are counterproductive in search of immediate performance gains. For example, a holding that may not perform well over a longer time frame because of growing climate risk may outperform in the very near term. There is little incentive to sell the holding if the manager perceives that it can seize an advantage over the benchmark in the short term.”
Fidler concedes that asset owners “have limited ability to motivate changes in asset manager compensation models”, but argues they can set terms and compensation structures for specific mandates.
He adds: “When adding new incentives and fee structures to an investment mandate to motivate a manager to invest for net zero, it is important that the compensation component tied to the net zero objectives is sufficient. If the net zero incentive is too small relative to the manager’s fee, it is unlikely to motivate behavioural changes.”
The Institute recommends asset owners gauge how to size the compensation component tied to net zero objectives relative to the fees and risks of the asset class being managed.
“It is critical that asset managers see any changes in fee structure as a win–win,” Fidler says. “Novel fee structures on a net zero mandate are especially meaningful if they are embraced by the team responsible for the mandate.”
The CFA Institute points to the world’s largest pension fund – Government Pension Investment Fund of Japan (GPIF) – as an example.
GPIF pays four of its external passive managers to implement engagement activities to “encourage investee companies to increase their corporate value and the sustainable growth of the entire market from the long-term perspective”.
