Social Funds Tie Pay to Impact ~ Wall Street Journal

We recently had the opportunity to contribute to a Wall Street Journal article discussing bonus structures for portfolio managers, and whether they should include impact or sustainability metrics.  This is a fascinating and very important topic: how do you assess a portfolio manager’s ability to have material impact on the economy, and incentivize appropriate behavior?  We are writing an extensive piece on the topic and will be publishing it soon – in the meantime, please enjoy the Wall Street Journal article.

Originally Published by the Wall Street Journal http://www.wsj.com/articles/social-funds-tie-pay-to-impact-1480907100
By Alex Davidson

if-ac853_social_j_20161202115557Plenty of investment professionals have their compensation tied to hitting specific financial targets. But does that metric make sense for increasingly popular socially responsible funds?

As these funds attract investors, some of the firms behind them have decided to tie the compensation of their portfolio managers to the impact the investments have made. The reasoning is clear: Investors in these funds are hoping to have an environmental and social impact, and managers’ compensation should reflect how well they achieve those goals.

Skeptics, however, question the effort. For one thing, measuring impact is a tricky endeavor. And second, they worry, such a compensation strategy could reduce returns significantly, as fund managers pursue doing good at the expense of doing well.

“Compensation has to be very carefully designed so that you’re creating the right enticements for behavior,” says Betsy Moszeter, chief operating officer at Green Alpha Advisors, an asset-management firm that focuses on sustainability and has one of the more advanced impact-based compensation structures among fund managers. In addition to managing investment portfolios, Green Alpha is a subadviser to Shelton Green Alpha, a mutual fund that focuses on green companies. “Having good incentives helps our marketing message and helps us talk to our clients,” Ms. Moszeter says.

Currently, Green Alpha uses financial returns and sustainability data from third parties to help it determine compensation for its portfolio and fund managers. Starting next year, sustainability ratings by fund researcher Morningstar Inc. also will be used to determine compensation for the two managers of the Shelton Green Alpha fund. Ms. Moszeter says that if the fund scores in the top 1% of sustainability funds, as ranked by Morningstar, the managers will qualify for a bigger bonus than if the fund fails to make the top 1%.

Another piece at Green Alpha, Ms. Moszeter says, is to look at what managers and analysts are doing to increase investor appetites for socially responsible investments. The thinking is that the more investors that portfolio managers and analysts can bring to the fund, the more investment there will be in socially responsible companies. Efforts of this kind that are encouraged, and rewarded, at Green Alpha include writing blog posts about investment choices and attending conferences to convince others of the merits of socially responsible investing.

“We make our methodology as bulletproof as possible because we know that people are going to try to poke holes in it,” Ms. Moszeter says. “We know there are naysayers. Our mission is that impact does drive performance.”

For companies looking to tie compensation to social and environmental impact, one of the biggest obstacles is measuring that impact in the first place. Some firms that specialize in sustainable investing rely on third-party providers of sustainability ratings, which in turn are based on such issues as a company’s use of energy or its water consumption. The third-party providers typically gather this information by submitting questionnaires to the companies. Some information is also gathered from companies’ public filings with the Securities and Exchange Commission. Such filings sometimes include details about business operations that have an impact on the environment.

Unfortunately, third-party providers of sustainability data tend to use different systems to measure impact, so firms that try to tie compensation to such measures have difficulty comparing efforts across the board. In addition, it is mostly larger companies with the resources to produce corporate social responsibility reports that have such data. Thus, there tends to be a bit of an information gap where smaller companies are concerned.

The lack of a gold standard in assessing sustainability gives some portfolio managers pause.

“Performance data is objective, standardized and audited,” says Billy Hwan, a portfolio manager at Parnassus Investments. “Measuring impact is not.”

Mr. Hwan, whose firm incorporates environmental, social and governance factors into its investment process, says his firm doesn’t link impact to compensation. He says without more reliable impact data, it is better to do research into a company before buying its stock, looking at both the fundamentals and sustainability perspectives, and then to compensate portfolio managers and analysts based on the performance of the stock.

“It’s important to consider both in tandem, but the ultimate measure of sustainability is in the returns,” he says. Truly sustainable firms will have healthy profits. For example, a company that saves water or energy might have lower operating expenses. Or, a company that pays fair wages can have less employee turnover and lower recruiting and retention costs. Thus, focusing on returns, Mr. Hwan says, is compatible with assessing sustainability.

Joseph Keefe, president and chief executive of the sustainable-investment firm Pax World Funds, echoes the sentiment that, while some firms are eager to show that their portfolio managers and analysts have skin in the game, the tools to accurately measure and account for impact aren’t there yet.

“There’s still not a lot of quantitative metrics out there. It’s a little bit hit or miss,” Mr. Keefe says. “To the extent impact can be measured, and to the extent incentive compensation might take impact into account, it will probably be important to avoid straitjacket numerical formulas in favor of a more nuanced approach.”

Mr. Keefe says his company takes an informal approach when it comes to tying impact to compensation. Impact is incorporated into some salary considerations, he says. Employees who write and work on shareholder resolutions, for example, are assessed on how many resolutions they wrote or whether they encouraged corporate dialogues around certain issues. Issues the company focuses on typically have an environmental or social bent, such as climate change and gender equality. But as a whole, Mr. Keefe says, salaries are still in mostly traditional formats.

“We would love to get there someday, yes,” he says of impact-based compensation structures. “But I think we’re in an early stage.”

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Important Disclosures http://greenalphaadvisors.com/about-us/legal-disclaimers/