Exclusions no lay down misere

This the first of a series of Posts covering the seven broadly recognised Responsible Investment Strategies.

Exclusions, also referred to as negative screens, is the most dominant responsible investment strategy in New Zealand according to the Responsible Investment Association Australasia’s (RIAA) Responsible Investment Benchmark Report NZ 2019.  Based on RIAA’s report 44% of Funds Under Management in New Zealand employ a negative screening approach.

Exclusions is the oldest form of sustainability investing and has been associated with those investors looking to manage their reputation risk.  Modern forms of negative screening have been around since the 1960’s.  The Philosophy dates-back to the 18th century.

 

Negative screening strategies exclude certain sectors, companies, or countries from a Fund’s investment universe.

Exclusions are often subjective decisions based on an investor’s values or are undertaken to avoid commonly called controversial business practices and products.  Examples of controversial activities are, Tobacco, Alcohol, Weapons, Gambling, Adult entertainment.

Other areas frequently excluded are animal testing, nuclear energy, genetically modified organisms, with the latter two often barred in Europe.  In recent years, it has become more common to exclude the worst climate offenders, including thermal coal and controversial oil and gas companies.

Exclusions can also be based on behaviour that is incompatible with sustainability standards or severe environmental or human rights violations. The Ten Principles of the UN Global Compact are often used as a guide in deciding which areas warrant exclusion.

 

Implementation Issues

Although Negative Screening appears to be a relatively straightforward strategy to implement, investors must ask themselves some difficult questions.

The devil is in the detail, and exclusions are no lay down misere.  There is a high degree of ambiguity.

 

Exclusion lists force investors to make absolute yes or no decisions, which can often mask the subtleties of some corporate activities. For example, a common industry excluded in ESG portfolios is tobacco. However, where does one draw the line with industries such as weapons manufacturing? Should only nuclear weapons manufacturers be excluded? What about handgun manufacturers?

The Exclusion process broadly involves the following steps.  Investors need to determine:

  1. Activities to avoid
  2. Materiality thresholds or the said activities (e.g. at least 5% of revenues).
  3. The investment universe is then screened, relying on a database. An immediate implementation issue is over quality of databases and variation in databases between providers (a subject of a future Post, highlighted now that subtleties and nuances excess in implementing).
  4. Companies breaching thresholds are removed from the investable universe and existing portfolios.  See below for materiality.
  5. Repeat with some frequency (e.g. quarterly or annually for Index providers and as stocks are research for active managers).

 

In my mind, a sound Responsible Investment (RI) philosophy and framework needs to be established first.  An RI Policy Document covering such should be developed and approved by the relevant Board.  Key exclusions would likely be included in the Policy.

I personally believe RI starts with Environmental, Social, and Governance (ESG) integration (ESG integration is another RI investment strategy which will be covered in a future Post).

An exclusion list is then developed based on the RI Philosophy (set of values) in the first instance and overtime based on the ongoing ESG research.

Exclusions without a philosophy or ESG research is management of reputation risk only, it has no solid foundation.  A wide sweeping corporate marketing statement does not constitute a RI Policy.

 

Materiality and Business Activities

Exclusion lists not only forces one to make absolute decisions on industries, they also force one to make absolute decisions on companies that have diversified businesses.

Therefore, a key question to answer before applying negative screening to a portfolio is where to draw the line. This entails two aspects: materiality thresholds and the nature of business involvement.

Materiality is relatively straightforward. Does an investor wish to eliminate issuers with any involvement at all in the excluded activities, or is there a tolerance for a small portion of revenues (e.g. no more than 5%) to arise from these areas?

The answer is personal.  There is a trade-off involved between the strictness of the threshold and the financial impact that may result from the exclusions.

 

The second point to consider is the nature of involvement in a given business activity.

A key distinction is between manufacturing and distribution.

In the case of alcohol, for example, should investors only exclude companies that produce alcohol or also those that derive a substantial portion of their revenues from it? And if they choose the latter, how exactly should they define a ‘substantial portion’? And if they are excluding alcohol manufacturers from their universe, what about the firms selling it, such as major retailers? Hotel Chains?

 

Therefore, it is important to understand what an exclusion will imply in practice.  Investors need to be comfortable with the results.  This can be challenging where there is a wide range of stakeholders.  Understanding the trade-offs involved is critical to avoiding surprises later.

 

The devil also lies in the detail when it comes to implementation.

This article by Man Numeric highlights the complexity of issues to consider in applying exclusions to the controversial weapons sector.  Providing a good discussion in relation to materiality and business activities.

 

Outcomes

Excluding a company rarely leads to its product being removed from the market. And excluding entire sectors for non-financial reasons can have a meaningful impact on the risk/return characteristics of a portfolio.

Exclusions are most suitable for investors with a clear vision and set of values on which products or behaviours they and their stakeholders wish to avoid. For example, charities with well-defined values and beliefs and health insurers that wish to exclude companies making products that are detrimental to general health.

 

Best in Class

While exclusion strategies adopt a negative approach, best-in-class strategies adopt a more positive stance, choosing to invest in the firms with the best ESG practices in a sector rather than deliberately avoiding certain areas. These strategies are based on the premise that firms with the best ESG practices are likely to outperform over the long term.  Best in Class will be the subject of a future Post.

 

ESG investing is a broad field with many different investment approaches addressing various investment objectives.

At a higher level ESG investing can be broken down to three main areas that each have their own investment objective:

  1. ESG integration, in which the key objective is to improve the risk–return characteristics of a portfolio.
  2. Values-based investing, in which the investor seeks to align their portfolio with their norms and beliefs. (i.e. Exclusions)
  3. Impact investing, investors use their capital to trigger change for social or environmental purposes e.g.to accelerate the decarbonisation of the economy.

 

Best practice includes exclusions, ESG integration with a focus on best-in-class, and Impact investing, a full array of Sustainable Investing strategies.

Crucially it requires an understanding of how to integrate ESG criteria into the investment process to capture the full value of ESG.

 

Happy investing.

Please see my Disclosure Statement

 

Global Investment Ideas from New Zealand. Building more Robust Investment Portfolios.

 

Unscrambling the Sustainable Investing Return Puzzle

“The evidence is compelling: Sustainable investing can be a clear win for investors and for companies. However, many SRI fund managers, who have tended to use exclusionary screens, have historically struggled to capture this. We believe that ESG analysis should be built into the investment processes of every serious investor, and into the corporate strategy of every company that cares about shareholder value. ESG best-in-class focussed funds should be able to capture superior risk-adjusted return if well executed.”

This is the key finding of a Deutsche Bank Group (DB) report published in 2012, Sustainable Investing, Establishing Long-Term Value and Performance

The DB report looked at more than 100 academic studies of sustainable investing around the world, and then closely examined and categorized 56 research papers, as well as 2 literature reviews and 4 meta studies.

To the point, they comment “… most importantly, “Environmental, Social and Governance” (ESG) factors are correlated with superior risk-adjusted returns at the securities level…..”

DB were surprised by the clarity of results. Which are as follows:

  • 100% of academic studies agree that companies with high ratings for Corporate Social Responsibility (CSR) and most importantly ESG factors have a lower cost of capital, for debt and equity. The market recognises them as having lower levels of risk.
  • 80% of studies show that companies with high ESG ratings exhibit market-based outperformance. The market is showing correlation between financial performance and what is perceived as the advantages of ESG strategies.
  • The single most important factor is Governance, Environment is next, closely followed by Social.

 

The study shows quite clearly that ESG factors matter at the security level, with consistent evidence of better financial performance.

The key for investors and fund managers is the ability to identify and capture these factors. This is a key issue as it comes down to the ESG scoring approach (whether active or index based) implemented, level and definition of portfolio exclusions.

It comes down to how ESG is integrated into the investment process.

 

Unscrambling Fund performance

A common perception is that Sustainable Investing is hard to define and provides mixed results – there is no really clear evidence it leads to a superior risk-adjusted return.

A key conclusion from DB is that “Sustainable investing has been too closely associated for too long with the performance of SRI Funds. These funds are not only an extremely broad category (i.e. in terms of investment mandate), but historically were based more exclusionary (or negative) – as opposed to positive best-in-class-screening.”

DB note that the Academic studies have not been aggregated and classified into appropriate categories, but have been mixed together, thus providing mixed results.

DB: “ By “unscrambling” them – as we do in this paper – a clearer picture emerges.”

 

“Socially Responsible Investing (SRI) in the academic literature have tended to rely on exclusionary screens – show SRI adds little upside, although it does not underperform either. Exclusion, in many senses, is essentially a value-based or ethical consideration for investors.”

With regards to the SRI Funds, the results are mixed, largely support they do not underperform, and there is no significant difference in performance.   Neutral to mixed results.

These results are limited to the review of SRI Funds only, they did not look at categories of ESG Funds.

 

DB found that ESG factors are correlated to superior performance at the security level, as highlighted above.

The real issue is how Managers are attempting to capture the superior performance from ESG factors at the security level in their portfolios.

Therefore, implementation and the approach taken to integrate ESG into the investment process is key in capturing the excess returns available from Sustainable investing as identified by the DB.

 

Increasingly, positive ESG investing, commonly referred to best-in-class, approach is being employed.

Best-in-class is an investment approach that focuses on companies that have historically performed better than their peers within a particular industry or sector on measures of environmental, social, and corporate governance issues. This typically involves positive or negative screening or portfolio tilting.

Best-in-class compares to exclusion, also called negative screening, where companies involved in certain “controversial” activities, such as tobacco or weapons are removed or excluded from an investor’s portfolio.

Best practice includes exclusions, ESG integration with a focus on best-in-class, and Impact investing, the full array of Sustainable Investing.

Crucially it requires an understanding of how to integrate ESG criteria in to the investment process, so as to capture the full value of the ESG factors.

 

Summary

DB note that the analysis on SRI performance goes a long way towards explaining why the concept of sustainable investing has taken so long to gain acceptance, it has been too closely associated for too long with the SRI fund manager results, which is a very broad category and has historically been based on exclusions, as opposed to a best-in-class screening.

They note that ESG investing, by contrast takes a best-in-class approach. DB have analysed the various categories within the universe of sustainable investing, they confidently say that the ESG approach, at an analytical level, works for investors and companies (in terms of lower cost of capital).

“It is now a question of ESG best-in-class funds capturing the available returns.” This is a key point.

So while Sustainable investing is the term use to refer to all form of investment, DB believe using ESG factors in a best-in-class approach is emerging as the key investment methodology. It is worth noting this was forecast in 2012 and is coming into fruition now.

DB note: “Investors should seek out investment managers who understand the ESG advantages and can leverage the information arbitrage that exists in the studies we examined. Sustainable Investing can pay dividends, but it requires managers who have internalised this information into their investment process and can also create appropriate strategies to help capture the upside that undoubtedly exists in this approach.”

Or put another way: “In effect, the conclusion is that there are superior risk-adjusted returns for investors, but managers need to take the right approach toward sustainable investing in order to capture these. For corporations, these are important results but the implication of lower cost of debt and equity capital must surely make this a key issue for any CFO, not just the CEO and Sustainability Officer.”

As an aside, this has implications in relation to the fee debate and manager selection. This will be covered in a future Post.

 

Another Comprehensive Study

A more recent study, ESG and financial Performance: aggregated evidence from more than 200 empirical studies, published in 2015 came up with similar conclusions.

They too found clear evidence in support of ESG investing. Their central conclusions was: “the orientation toward long term responsible investing should be important for all kinds of rational investors in order to fulfil their fiduciary duties and may better align investors’ interests with the broader objectives of society. This requires a detailed and profound understanding of how to integrate ESG criteria into investment processes in order to harvest the full potential of value-enhancing ESG factors……..”

As  mentioned, implementation is key. Therefore, when selecting an index provider or/and active manager, their integration of ESG factors into the investment process and strategy is very important, as also highlighted by the DB study.

The full conclusion of the 2015 study:

“Through a second-level review of 60 review studies – including both, vote-count studies and meta-analyses – on the ESG–CFP relation, we are able to combine more than 3700 study results from more than 2200 unique primary studies. Based on this sample, we clearly find evidence for the business case for ESG investing. This finding contrasts with the common perception among investors. The contrary perception of investors may be biased due to findings of portfolio studies, which exhibit, on average, a neutral/mixed ESG–CFP performance relation. It is important to be aware that the results of these (to date about 150 studies) are overlaid by various systematic and idiosyncratic risks in portfolios and, in the case of mutual funds, by implementation costs. Still more than 2100 other – in particular company-focused – empiric studies suggest a positive ESG relation. ESG outperformance opportunities exist in many areas of the market. In particular, we find that this holds true for North America, Emerging Markets, and in non-equity asset classes. Our results propose that capital markets so far demonstrate no consistent learning effects regarding the ESG–CFP relation: Since the mid-1990s, the positive correlation patterns in primary studies have been stable over time.

 Based on this exhaustive review effort, our main conclusion is: the orientation toward long-term responsible investing should be important for all kinds of rational investors in order to fulfil their fiduciary duties and may better align investors’ interests with the broader objectives of society. This requires a detailed and profound understanding of how to integrate ESG criteria into investment processes in order to harvest the full potential of value-enhancing ESG factors. A key area for future research is to better understand the interaction of different ESG criteria in portfolios and the relevance of specific ESG sub-criteria for CFP. These insights will shed further light on the ESG determinants for long-term positive performance impacts.”

 

Happy investing.

 

Please see my Disclosure Statement

 

Global Investment Ideas from New Zealand. Building more Robust Investment Portfolios.