ESG Integration

Active Engagement, Stewardship, and Taxonomy key Responsible Investing Issues

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Active engagement and stewardship have leapt in importance as a way for asset managers to drive sustainable change. This is a key conclusion of a study undertaken by Schroders in 2020. 

Schroders conclude “The results suggest that engagement and voting are now increasingly being viewed as an important aspect of achieving change, rather than simply divesting.”

Their study found that nearly 60% of “institutions said active company engagement and stewardship was a key approach to integrating sustainability.” This is a significant rise on 38% a year ago.

The survey also highlighted:

  • ESG Integration into the investment process and positive screening (focusing on the best in class companies) are the top two important drivers for asset managers to drive sustainable change;
  • Positive screening has also grown sharply in importance, from 44% of survey respondence to 61%; and
  • Conversely Negative Screening has fallen in importance (53% to 36%).
Source: Schroders

Investors noted signs of successful engagement included:

  • Transparent reporting;
  • Tangible outcomes; and
  • Consistently voting against companies in order to drive change.

Greenwashing, poor data, and increased Regulation

Greenwashing, as described by Schroders “‘a lack of clear, agreed sustainable investment definitions’” was seen as the most significant obstacle to investor’s sustainable investment intentions.  60% of those surveyed found green-washing as one of the most significant obstacles impeding their sustainable investing intentions.

The lack of transparency and reported data was also raised as an issue restricting the ability to invest sustainably.

Both measures increased in importance on last year, while performance concerns continued to decline.  45% of investors cited performance as concern in relation to investing sustainably.

Source: Schroders

These results were recently picked up in an Alternative Investment Management Association (AIMA) article, which focused on the increased integration of ESG into Hedge Fund’s investment processes.  Hedge funds start integrating ESG (aima.org).

In relation to green-washing, AIMA notes that regulators are also concerned about green-washing, noting the introduction of the Sustainable Finance Disclosure Regulation (SFDR) rule in the European Union.  The SFDR came into effect on March 10 of this year, aimed at ensuring financial firms such as fund managers, insurers, and banks providing financial products and services comprehensively disclose just how committed to sustainability they truly are.

The AIMA notes “The EU rules will also create a taxonomy as regulators look to facilitate greater consistency in terms of what can be classified as being a sustainable economic activity.”

The AIMA also noted more global investors are now prioritising ESG, and it is something which hedge funds need to respond to.  Although they felt the US was behind the rest of the world, particularly Europe (I would add Australian and New Zealand as well), this was changing.

By way of example, the AIMA article highlighted “that several high profile US institutions – including the likes of CALPERS and Wespath – have signed up to the UN-backed Net Zero Asset Owner Alliance, a consortium comprised of 30 of the world’s largest investors – all of whom have committed to reduce carbon emissions linked to the companies they invest in by 29% within the next four years.”

Failure to transition towards net zero is widely seen as a important risk management issue for companies. Arguably, companies failing to adapt or transition towards net zero will see their businesses and valuations suffer.

Lastly, AIMA highlighted the concerns over the quality of ESG data being disclosed by managers to their investors.

“One of the primary problems is that there are no harmonised ESG data standards. Instead, there are many different ESG standards and protocols, all of which have their own characteristics. With different managers subscribing to different ESG standards, the reports they produce for clients are often inconsistent and even contradictory. Similarly, ratings agencies will often have their own bespoke methods of collecting data from companies they are scoring. ……… Without a common data collection methodology, the ratings agencies’ scoring processes will be fragmented.”

Key Engagement Issues

The survey by Schroders found environmental issues remained the most important engagement issue for investors.

In total, 68% of investors globally said they expected investing sustainably to grow in importance over the next five years.

“Driving this focus were institutions looking to align their investments with their own corporate values, responding to regulatory and industry pressure, and, positively, the belief that investing sustainably can drive higher returns and lower risk.”

The Schroder study included 650 institutional investors encompassing $25.9 trillion in assets.

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Is ESG an Investment Factor? Can ESG be easily harvested?

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“ESG is not an equity return factor in the traditional, academic sense”.…… “Nevertheless, ESG can be a very powerful theme in the portfolio management process in the years ahead.” 

These are two key conclusions from a recent Research Affiliates article, Is ESG a Factor?

ESG investing is incorporating Environment, Social and Governance considerations into investment portfolios.

Research Affiliates conclude “that ESG does not need to be a factor for investors to achieve their ESG and performance goals.”

They also call for greater clarity around exactly what ESG is and what it is not. 

“Currently, various stakeholders are sending a whole host of mixed messages. Investors, particularly fiduciaries, need education and alignment. If ESG remains a heterogeneous basket of claims, we will likely never see it fulfill its vast promise.”

Lastly, they believe ESG is likely to be a powerful theme for the new owners of capital, in particular woman and millennials.  Increasingly investors will prioritise ESG in their portfolios in the years ahead.

In my view, it is a stretch to say ESG is an investment factor in the context of Factor Investing.  Nevertheless, the active management of ESG considerations into the investment process has the potential to add value.

You can’t capture the benefits of ESG by just being an ESG investor.  Capturing the benefits from ESG are harder to attain relative to implementing an equity factor strategy such as value or low volatility. 

The risks, and therefore the rewards of ESG, are more company specific.

Therefore, it is not good enough to say one incorporates ESG into the investment management process to gain the benefits from ESG. 

There is no specific ESG factor that can be “harvested” passively.  The ESG value add comes from implementing successfully and having the ability to identify company specific ESG risks. 

What Is a Factor?

Before we can determine if ESG is an investment factor we first need to establish what an investment factor is.

In short, factors are characteristics associated with long-term risk and return outcomes associated with investing into a group of securities. 

The “market”, sharemarkets and fixed income markets are factors themselves (Market Factors).  We know that over time we can expect to generate a return over cash, a premia over cash (premia), from investing in sharemarkets, credit markets (corporate debt), and longer-term fixed income securities (interest rate duration).

Within markets there are also investment factors, which have been shown to deliver a premia (excess return adjusted for risk) over the “market factors” identified above.

The most common of these investment factors, and one receiving a lot of media attention currently, is the value factor.  There are other well know and academically supported factors, including momentum, carry, quality, and low volatility. Investment factors are also known as Premias or Style Premia.

To be considered a robust investment factor, it is generally considered their needs to be support from an economic perspective or there is a behavioural-based explanation for the factor.

For those interested, I have previously Posted on Factor Investing, and this article on Andrew Ang discussing Factor Investment might also be of interest.

Research Affiliates have their own framework on determining the robustness of a Factor, which can be found here.

The Evidence – Is ESG an investment Factor?

To determine if ESG is a factor, Research Affiliates maintain it should satisfy the following three critical requirements, it should be:

  1. grounded in a long and deep academic literature;
  2. robust across definitions; and
  3. robust across geographies.

Academic Literature

The common factors of value, momentum, and low beta have been thoroughly researched and have a track record spanning several decades, as Research Affiliates conclude “very little debate currently exists regarding their robustness.”

In reviewing the academic literature on ESG, Research Affiliates find little agreement on the robust of generating excess returns.  (Their article provides a good source of academic ESG research for those interested.)

In their view ESG is not an equity return factor in the traditional academic sense.

I have posted previously on the Research spanning Responsible Investing, see: Unscrambling the Sustainable Investing Return Puzzle. 

In my mind there is value in undertaking a Responsible Investing approach, including the incorporation of ESG into the investment management process.  This can be the case yet ESG not be a Factor as defined in academia.  The research covered in the above Post provides support for this view.

Factors should be robust across definitions. 

This is an interesting observation.  Research Affiliates argue that “even slight variations in the definition of a factor should still produce similar performance results.”

They use value as an example, using different valuation metrics for value results in similar results over the longer-term.  The value factor is robust across different definitions of value.

Unfortunately, ESG does not have a common definition and is a broad continuum of philosophies, approaches, and strategies.

See a previous Post discussing the continuum of Responsible Investing, which includes ESG: Sustainable Responsible Investing Spectrum

The broad spectrum is highlighted in the following Table presented in the Research Affiliates article to emphasise “ESG has no common standard definition and is a broad term that encapsulates a range of themes and subthemes.” 

As they note, the strategies align more with investor preferences rather than a particular investment factor.  

In the article Research Affiliates present the findings of their research to display how variations in the definition of ESG results in different performance outcomes.

From this analysis, they conclude:

  1. None of the ESG strategies as defined displayed material excess returns;
  2. There was a lack of historical track record, which is a significant impediment to conducting research in ESG investing; and
  3. Only after decades of quality data will it be possible to accurately test the claim that EG is a robust factor.

Research Affiliates also highlight there is an issue with the lack of consistency among ESG rating providers which hinders the ability to determine if ESG is a robust factor.  They provide an example of this in the Article.

With regards to the last requirement, Research Affiliates find that ESG performance results are not robust across regions.

ESG Is Not a Factor, but Could Be a Powerful Theme

“ESG does not need to be a factor for investors to achieve their ESG and performance goals.”

Encouragingly, Research Affiliates see a role for the incorporation of ESG within an investment portfolio. I Agree!

They highlight that there are companies with poor ESG characteristics and that these risks should be incorporated into the stock selection process.

These risks are company specific risks, idiosyncratic risks technically speaking.

Research Affiliates consider carbon as an example, particularly coal.  Notably there has been a move away from coal in the US.  Therefore, “Investment managers who do not consider and integrate the ESG risk of, in this case, climate change may be blindsided.”

The successful implementation of ESG is a key determinant in capturing the value from company specific characteristics.  Specifically, having the ability to identify mispricing of securities due to ESG risk.

It is not good enough to say one incorporates ESG into the investment management process and therefore the portfolios will benefit. 

There is no a specific ESG factor that can be “harvested” passively, the value add comes from implementing successfully and having the ability to identify company specific risks. 

Increasing Adoption of ESG Investing

Lastly, and quickly, Research Affiliates note that there is a “large shift in investor preference toward ESG is occurring as two distinct groups—women and millennials—take greater control of household assets.”  This is backed up by third party research which notes that there will be a wave of assets ready to invest in highly rated ESG companies.

A regulatory push globally is also likely to accelerate this trend.

Happy investing.

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

Developing ETF Trends and Innovations – EDHEC Risk Research

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The most recent EDHEC Risk Institute’s European Exchange Trade Funds (ETF) survey* provides valuable insights into the developing trends and innovation in relation to the use of ETF in a diversified and robust portfolio.

The following Post outlines the key findings of the EDHEC ETF survey, which is well worth reading.

 

The changing Purpose of using ETFS

Increasingly ETFs are being used for tactical allocation purposes. Historically the dominant purpose of ETF usage has been to gain a truly passive investment, a long-term buy-and hold investment to gain broad market exposures via the major market indices.

Results by EDHEC indicate there is now a greater usage of ETFs for tactical allocations rather than their role for long-term positions (53% and 51% respectively).

The survey also noted:

  • Gaining broad market exposure remains the focus of ETF for 73% of users, compared with 52% of respondents using ETFs to obtain specific sub-segment exposure.

 

As EDHEC note, the increasing focus on sub-segment exposures can be linked to product development, “which has led to the introduction of new products for a multitude of sub-segments of the markets (sectors, styles etc.). It also correlates with the growing use of ETFs for tactical allocations, which tend to favour a more granular investment approach over broad exposures.”

 

ETF Use continues to Grow**

The adoption of ETF continues to grow, particularly for the traditional asset classes. “In 2019 91% of respondents used ETFs to invest in equities, compared with 45% in 2006. As for governments and corporate bonds, the result went from 13% and 6% in 2006, to 66% and 68%, respectively, in 2019…”

“Investors prefer ETFs for traditional asset classes over alternative asset classes in line with this expression of conservatism in their use of ETFs, which is mainly focused on gaining access to broad market exposure”….

The Survey recorded a high level of satisfaction by investors with ETF in the traditional asset classes.

The survey also notes:

  • A high percentage of investors (46%) still plan to increase their use of ETFs in the future, despite the already high maturity of this market and high current adoption rates
  • Lowering investment cost is the primary driver behind investors’ future adoption of ETFs (74% of respondents in 2019).
  • ETF investors are planning to increase their ETF allocation to replace active managers (71% of respondents in 2019) and replace other passive investing products through ETFs (42% of respondents in 2019)

 

Future Growth and ETF Innovation Drivers

“Ethical/SRI and smart beta equity / factor indices are the main expectations for further development of ETF products”

Further developments where called for in the following market segments:

  • 31% of respondents wished for further development of Ethical/Socially Responsible Investing (SRI) ETFs.
  • ETFs related to advanced forms of equity indices – namely those based on multi-factor and smart beta indices – 30% and 28% of respondents

 

In aggregate 45% of respondents would like further development in one of the following areas of either smart beta indices, single-factor indices, and multi-factor indices.

 

More specifically, the EDHEC Survey found that “respondents would like to see further development of smart beta and factor investing products in the area of fixed income”……“The integration of ESG into smart beta and factor investing, and strategies in alternative asset classes (currencies, commodities, etc.), closely follow.”

 

EDHEC conclude, “It is likely that the development of new products corresponding to these demands may lead to an even higher take-up of smart beta and factor investing solutions.”

 

Criteria for selecting ETF Providers

The two main drivers of selecting an ETF provider are Cost and the quality of Cost and Quality of Replication. These two criteria dominate the survey results.

The long-term commitment of the provider, range of solutions, and level of innovation also rank highly.

 

Smart Beta and Factor Investing

The EDHEC Risk Survey has a large section on the drivers of using Smart Beta and Factor Investing Strategies.

Motivation for Smart Beta and Factor investing strategies include improving performance and managing risk

Albeit, the adoption of these strategies is a small fraction of portfolio holdings.

 

Concluding Comments

EDHEC found that there was a preference for passive for open-ended passive funds to invest in equity products, and active solutions to invest in fixed income products.

In relation for smart beta and factor investing the “take-up remains partial despite more than a decade of discussion in the industry, with the vast majority of adopters investing less than 20 per cent of their portfolio in such approaches.”

They find that this is partly due to a lack of ‘transparency and difficulty in accessing information about such strategies”….“In the case of fixed income strategies, investors express doubts over the maturity of research results at this stage. They also see a need for further development of long/short equity strategies based on factors, strategies that address client-specific risk objectives, and strategies that integrate environmental, social and governance (ESG) considerations.”

Personally, I see an increasing demand for smart beta and factor investing within fixed income strategies. Whether this is within an ETF structure, time will tell.

 

Therefore, for product provides to capture the growth and innovation outlined above, as EDHEC highlight, there is work to be done “to improve their solutions for smart beta and factor investing strategies if they are to make it into the mainstream.”

This is an area of opportunity for ETF providers, particularly if it includes an ESG overlay.

 

Happy Investing

 

Please read my Disclosure Statement

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

 

* The 2019 EDHEC survey gathered information from 182 European investment professionals concerning their practices, perceptions and future plans. Respondents are high-ranking professionals within their organisations (34% belong to executive management and 42% are portfolio managers), with large assets under management (42% of respondents represent firms with assets under management exceeding €10bn). Respondents are distributed across different European countries, with 12% from the United Kingdom, 70% from other European Union member states, 14% from Switzerland and 4% from other countries outside the European Union.

* *  At the end of December 2018, the assets under management (AUM) within the 1,704 ETFs constituting the European industry stood at $726bn, compared with 273 ETFs amounting to $94bn at the end of December 2006 (ETFGI, 2018b).

Exclusions no lay down misere

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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.

 

Changing the Conversation on Management Fees

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Bloomberg report:

“BlackRock Inc. is tired of the conversation about costs. The world’s largest asset manager, which runs some of the cheapest investment products available, plans to place a greater focus on the quality of the engineering, construction and management of its funds going forward, …… “

“There’s too much emphasis purely on cost,” said Senra, ……….. “We don’t talk enough about quality. That’s not to say we’re not going to be competitive — we have to be competitive, this is a competitive industry — but I would move away from just a low-cost conversation.”

 

I agree, “too much emphasis purely on cost”, investment management fees, there should be a “greater focus on the quality of engineering, construction, and management”, and “we don’t talk enough about quality”.

 

Now don’t get me wrong, I think investment management fees are important.  I also think we should have a mature discussion about fees.  

The cheapest solution may not be the best, a race to bottom is not helpful.  And I’d say, not necessarily in the best interest of investors.

 

There are many reasons why you might consider paying more for something.  In an investing context this could be for greater levels of true portfolio diversification to manage portfolio volatility and return outcomes, for example the model followed by US Endowment Funds which has been very successful.

 

I appreciate BlackRock is making comment in relation to gaining access to certain areas of the market that they believe will deliver greater return outcomes overtime. 

 

I think this is an interesting issue when framed in the context of Responsible Investing.  Particularly in relation to quality of data, portfolio construction, and portfolio management.   From a more broader perspective, it also  helps highlight issues beyond just a headline investment management fee.

 

The evidence is compelling, Environmental, Governance and Social (ESG) investing can be a clear win for companies.  It can also be a clear winner for investors, yet it is not easy to capture this value.

For a start the ESG data is not consistent across providers.  At the company level this creates a diversity of opinion amongst providers.  Several studies have highlighted the contrasting conclusions of ESG data providers. (See this article on ESG Scoring, sourced over LinkedIn and published by RBC GAM.) 

Studies highlight the low level of correlation between ESG data.  This can result from different weighting systems that generate an ESG score and that there is a level of subjectivity in determining the materiality of ESG input.

 

Let’s consider this from a New Zealand perspective.

As the recent RIAA Benchmark Report  highlights:

“When primary and secondary RI strategies are taken into account, the dominant responsible investment strategy is negative screening, which represents 44% of AUM. Where ESG integration was nominated as the primary strategy, it was usually paired with either corporate engagement and shareholder action, or negative screening, as secondary strategies.”

Negative Screening is the dominant Sustainable Investing approach in New Zealand, to move beyond this will take an increasing level of resources and time.

There is a lot more to RI than negative screening.  The implementation of negative screening is not straight forward i.e. coming up with the investment philosophy, approach, and framework takes time and consideration, trading on the exclusion list is relatively straight forward.

 

As the RIAA Report covers, there are seven broad RI strategies as detailed by the Global Sustainable Investment Alliance (GSIA) and applied in the Global Sustainable Investment Review 2018, which maps the growth and size of the global responsible investment market.

The Broad RI strategies are:

  1. ESG integration
  2. Corporate engagement and shareholder action
  3. Negative/exclusionary screening
  4. Norms-based screening
  5. Positive/best-in-class screening
  6. Sustainability-themed investing
  7.  Impact investing and community investing

 

Best practice RI involves the full spectrum of these strategies, negative screening, ESG integration, Best-in-class and impact investing, at the very least.  This includes corporate governance and shareholder action.

 

So how do New Zealand’s leading investment managers compare to best practice.  The RIAA report makes the following comment in relation to New Zealand managers:

“There’s a growing number of investment managers applying leading practice ESG integration, but the overall number remains small. Of the 25 investment managers assessed, just eight (32%) are applying a leading approach to ESG integration (score >80%). That said, the number of leading ESG integration practitioners has risen from four last year, with some employing other responsible investment strategies as their primary strategy.”

 

It is great to see ongoing progress.

To implement leading ESG integration practices, let alone capture the full value of the ESG factors, takes time and resources.  Those managers making this commitment are to be commended.  It takes a lot of hard work.

The market leading managers are applying a wide range of sustainable investing approaches and resources.  This comes at a cost.

 

Therefore, some thought must be given to quality of RI outcomes being delivered and are they in line with best practice and is there continuous improvement in place.  Do they meet customers expectations?

 

Accordingly, I agree, let’s change the conversation about investment management fees, there are a lot of issues to consider other than investment management fees alone.

There is a lot to consider in delivering robust outcomes to investors.

Happy investing.

 Please see my Disclosure Statement

 

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

Unscrambling the Sustainable Investing Return Puzzle

/ Kiwi Investor / 4 Comments

“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.

 

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