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

“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.

Please see my Disclosure Statement

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

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.

 

Changing the Conversation on Management Fees

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

“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.

 

Not Investing Responsibly

The United Nation’s responsible investing body, Principles for Responsible Investment (PRI), could delist up to 50 groups next year, as reported by the FT.

Seemingly, almost a third of the PRI signatories placed on a watchlist by the PRI are at risk of being booted out of the body next year.

Last year the PRI put 180 of its signatories on notice after an annual audit suggested they had not demonstrated a minimum standard of responsible investment activity.

 

Signatories to the PRI, which include asset owners and managers, commit to six principles (See below) designed to embed environmental, social and governance (ESG) considerations into mainstream investing and holding companies they invest in to account on ESG failures.

Signatories must file an annual report to the PRI detailing their progress. And continuing to make progress is key. An organisation has to do more each year. You are either in or you are out!

 

According to the FT article, the PRI last year gave those on the list two years too lift their game. The responsible investment body said 88 on the watchlist made improvements and met the minimum requirements this year. It is also working with 42 signatories who are on track to do so by 2020.

However 50 groups with $1tn in assets have failed to engage with efforts to get them to shape up and are at risk of being delisted. The PRI refused to name names.

As the article highlights “The move comes at a time of greater scrutiny of whether investors are practising what they preach when it comes to responsible investment. “We still have some where they haven’t met with us,” said Fiona Reynolds, chief executive of the PRI, who said it was hard to know why they have not done so. “The aim was always to get people moving, not to delist people.” The PRI also requires that at least half a fund manager’s assets be covered by a responsible investing policy and for there to be explicit commitment to the issue by senior managers.”

 

Raising the Bar on free riders

This comes after the PRI signalled last year they were raising the bar by introducing new minimum hurdles. PRI is also pushing its 1900-plus members to be more active on issues like climate change, human rights and corruption. The SMH reported that collectively this group has US$70 trillion in assets under management.

As outlined by the SMH “The PRI put in place minimum requirements, a move it hopes will strip out free-riders in its ranks while bolstering its relevance, more than 10 years after the PRI’s launch by then-United Nations secretary general Kofi Annan and a group of major institutions……….. “And it wants its members to be more active in holding companies to account on so-called ESG – environmental, social and governance – issues, with climate change risks, fracking, corruption, water rights, modern slavery and child labour among its current areas of focus.”

 

As noted in the SMH article many PRI signatories proudly tout their membership, sustainability reports and marketing materials, but about 10 per cent would not currently meet the proposed new hurdles.

 

Responsible investing is more than establishing portfolio exclusions.

Being a PRI signatory takes a real commitment. Increasingly the PRI is asking signatories to be more active. This includes investors wield their proxy votes against company management when more gentle forms of engagement – like letters to boards and meetings – fail to get results.

Collaborating with the industry is also a key component of being a signatory, e.g. PRI members have collectively pushed for more disclosure on issues like water quality, air emissions, and community consultation and consent by fracking companies, and for improved labour practices in agricultural supply chains.

Also, late last year, the PRI backed the Climate Action 100+ campaign, launched by 200 institutional investors with US$26 trillion in assets under management, which aims to push 100 high-emitting companies including BHP, Rio Tinto and Wesfarmers to curb emissions and boost climate risk disclosure.

 

As outlined in a previous post, increasingly best practice involves incorporating ESG Integration, Exclusions, and Impact Investing into the investment process and implementing across a variety of asset classes i.e. not just equities.

Furthermore, while exclusions adopt a negative approach, increasingly the ESG research is being applied in a positive way i.e. investing in companies with the best ESG practices rather than just avoiding those with the worst practices.

 

Signatory Requirements

PRI signatories are required to report once a year on their activities, pay their fees and declare their intention to invest responsibly via the six voluntary and aspirational principles.

They also have to:

  • have a responsible investment policy that covers at least 50 per cent of their assets under management,
  • name a person within the organisation that is responsible for carrying it out, and
  • spell out who in their group’s senior ranks is accountable for it.

 

As the SMH records they are not particularly high hurdles.

It is not that onerous and it is amazing what can be achieved with steady incremental improvements.

 

How to avoid being on the PRI Black List?

A recent UBS Survey highlighted that a lack of internal resources was one of the most important barriers to ESG related thinking. Unclear terminology was another, along with a fear it will hurt financial performance (I hope to blog on this barrier later).

A lack of internal ESG implementation knowledge, particularly on Boards and Trustees can not only be a barrier to taking the first steps toward being a Responsible Investor, it is also a barrier for the advancement and continuous improvement of the Responsible Investing approach the PRI is looking for.

Terminology is a barrier but can be easily overcome.

Furthermore, from this perspective, the first step an organisation should take when adopting ESG and a Responsible Investing approach is to formulate a Policy. This signals a genuine intent to start integrating ESG. The Policy should be Board approved.

Therefore, very surprisingly, the USB Survey found that only a minority of ESG adopters (7%) had established a Policy. This is staggering. 40% of the survey respondents said no – but would like to do this! wow. 30% just said no.

The UBS ESG Survey, Do you or don’t you? Received 613 responses from asset owners, across 46 countries representing EUR19 Trillion in assets.  Not all the respondents were PRI Signatories.

 

Happy investing.

Please see my Disclosure Statement

 

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

 

PRI Principles

Principle 1: We will incorporate ESG issues into investment analysis and decision-making processes.

Principle 2: We will be active owners and incorporate ESG issues into our ownership policies and practices.

Principle 3: We will seek appropriate disclosure on ESG issues by the entities in which we invest.

Principle 4: We will promote acceptance and implementation of the Principles within the investment industry.

Principle 5: We will work together to enhance our effectiveness in implementing the Principles.

Principle 6: We will each report on our activities and progress towards implementing the Principles.

Sustainable Responsible Investing Spectrum

The terminology used in relation to Responsible Investing can be confusing. For example, often the terminology Responsible Investing gets confused by some to mean exclusively Ethical Investing or Social Responsible Investing (SRI).  Both of which have been shown to deliver below market returns.  They are separate activities along the Responsible Investing continuum.

At an institutional Funds Management level Responsible Investing (RI) has been associated with the United Nations Principles of Responsible Investing (PRI).  PRI has six principles, see below.

Often sector/stock exclusions are implemented and/or an overlay or integration of taking into consideration Environmental, Social and Environmental (ESG) criteria is employed.

This approach to RI has been around for some time, particularly in Europe and Australia.

It is now well established that considering or integrating ESG information leads to better-informed investment decisions.

 

However, the Sustainable Development Goals (SDG) are an important recent development. The SDG are a collection of 17 global goals set by the United Nations General Assembly in 2015 for the year 2030.

The SDG take Responsible Investing, sustainability, to the next level by making it more tangible and measurable.

 

As a result, there is a growing and important change in the approach toward RI, from just avoiding those companies with a negative impact on the environment to investing in companies that have a positive way.

Therefore, SDG have impacted RI in a couple of important ways:

  • The RI continuum has become more defined with the increased focus on Impact Investing.  As presented in the Table below, the RI continuum moves from “Financial Only” to “Impact Only”
  • Industry terminology is moving on from RI to Sustainable Investing.

 

The Continuum of “Responsible Investing”

Financial Only Limited or no regard for environmental, social or governance practices
Responsible (ESG) Mitigate risky environmental, social or governance practices in order to protect value
Sustainable Adopt progressive environmental, social or governance practices that may enhance value
Impact (a)

Financial

Address societal challenges that generate competitive financial returns for investors
Impact (b)

Likely below market Returns

 

Address societal challenges which may generate a below-market financial return for investors

Impact (c)

Require below Market Returns

Address societal challenges that require a below market financial return for investors
Impact Only Address societal challenges that cannot generate financial return for investors

The information in the above Table is sourced from: Lessons from Social Impact Investment Taskforce: Asset Allocation Working Group, 12 December 2014.

 

Using the Table above, the RI continuum starts at “Financial Only” considerations and ends at “Impact Only” considerations.  Using this continuum the following observations can be made in relation to the objective(s) each RI category is focusing on achieving, there is an overlapping nature:

  1. Generating competitive financial returns are an object starting from Financial Only and persisting to Impact (b).
  2. The objective of mitigating Environmental, social and governance risks starts from Responsible (ESG) and continues right through to Impact Only
  3. The Pursuit of environmental, social, and governance “opportunities” starts at Sustainable and is maintained through to Impact Only
  4. The goal of focusing on measureable high-impact solution obvious begins with Impact (a) and until Impact Only.

 

Therefore, as mentioned, RI is increasingly encompassing sustainability. Sustainable Investing.

The UN-backed Principles for Responsible Investment explains sustainability investing as follows: “We believe that an economically efficient, sustainable global financial system is a necessity for long-term value creation. Such a system will reward long-term, responsible investment and benefit the environment and society as a whole.”

Fund managers, such as RobecoSAM, would use the term sustainability investing to mean “the pursuit of superior financial returns coupled with positive environmental, social and corporate governance outcomes”.

Sustainable Investing can be thought of as having three main components:

Integration

Using ESG information to improve the risk and return profile.

Exclusions

Avoiding investment in areas of controversial products or business practices.

Impact

Investing for socioeconomic impact alongside the financial returns.

 

Each of these components could be done in isolation or in combination with each other.

Increasingly best practice is incorporating all three components into the investment process and implementing across a variety of asset classes i.e. not just equities.

Furthermore, while exclusions adopt a negative approach, increasingly the ESG research is being applied in a positive way i.e. investing in companies with the best ESG practices rather than just avoiding those with the worst practices.

 

Overtime, I hope to cover off each of the Sustainable Investing components outlined above in separate posts and will provide links.

 

I will leave the final thoughts to RobecoSam, where they quite rightly draw the link between sustainable investing and delivering competitive financial returns from investing.

Finance has a role to play!

“Financial materiality is the critical link at the intersection of sustainability and business performance. More specifically, investors should focus on identifying the most important intangible factors (sustainability factors) that relate to companies’ ability to create long-term value. For instance, lowering energy consumption in manufacturing processes results in significant cost-saving opportunities and has a direct impact on a company’s bottom line. Going a bit deeper, financial materiality is defined as any intangible factor that can have an impact on a company’s core business values. These are the critical competencies that produce growth, profitability, capital efficiency and risk exposure. In addition, financial materiality includes other economic, social and environmental factors such as a company’s ability to innovate, attract and retain talent, or anticipate regulatory changes.

These matters to investor because they can have significant impacts on a company’s competitive position and long-term financial performance. “

 

These sentiments were echoed in a recent FT article.

 

Happy investing.

Please see my Disclosure Statement

 

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

 

UNPRI Principles

 

Principle 1: We will incorporate ESG issues into investment analysis and decision-making processes.

Principle 2: We will be active owners and incorporate ESG issues into our ownership policies and practices.

Principle 3: We will seek appropriate disclosure on ESG issues by the entities in which we invest.

Principle 4: We will promote acceptance and implementation of the Principles within the investment industry.

Principle 5: We will work together to enhance our effectiveness in implementing the Principles.

Principle 6: We will each report on our activities and progress towards implementing the Principles.

Impact Investing – a large and growing market

A recent Report by the Global Impact Investing Network (GIIN) estimated the size of the Global Impact Investing universe to be $502 billion (see: Sizing the Global Impact Investing Market).

It is important to note this is a separate measure “to estimates of the size of related markets (such as ESG or socially responsible investing). Neither, of course, are accurate or complete indicators of the current impact investing market size.”

 

The GINN report defines “impact investing as investments made with the intention to generate positive, measurable social and environmental impact alongside a financial return. Impact investments are made in both emerging and developed markets as well as across all asset classes, including private and public markets.”

 

They also note that impact investing has gained significant momentum over the last decade “as both an investment strategy and an approach to addressing pressing social and environmental challenges. Through impact investments, investors seek to generate both a financial return and positive, measurable social and environmental impact.”

 

The Article provides a detailed explanation of their approach and types of organisations included in the analysis. There is also a section on how to interpret the results.

The database captures many types of organizations. Over 60% are asset managers. About one in five are foundations, and the rest include banks, development finance institutions, family offices, and institutional asset owners.

The database also includes a global group of investors. The majority are based in developed markets, including the U.S. and Canada (58%) and Western, Northern & Southern Europe (21%). It also includes investors based in regions like Sub-Saharan Africa, Latin America & the Caribbean, the Asia-Pacific, and the Middle East & North Africa.

 

 

Market Size

GIIN estimates the overall global impact investing industry AUM is USD 502 billion, as of the end of 2018.

They estimate that there is over 1,340 active impact investing organizations across the world.

They also estimate the median investor AUM is USD 29 million, the average is USD 452 million, indicating that while most organizations are relatively small, several investors manage very large impact investing portfolios.

Overall, asset managers account for about 50% of estimated AUM who typically channel capital via specialized managers.

Investments are across the board, including venture capital, private equity, fixed income, real assets, and public equities.

This is an important study, previously, as they noted in their article, a well-defined estimate of the size of the impacting market did not exist. This provides a benchmark to measure future industry growth.

 

Conclusions

The GIIN Report concludes as follows:

“Since the term ‘impact investing’ was formally coined in 2007, the industry has grown in leaps and bounds. With a growing recognition of the power of investment capital to address pressing social and environmental challenges, impact investing has attracted the attention of an increasing number of investors of all types and from all over the world. Indeed, over 50% of active impact investing organizations made their first investment in the past decade.

This research shows that there are over 1,340 active impact investing organizations across the world who collectively manage USD 502 billion in investments intended to bring about positive change. These figures are a snapshot as of the end of 2018, yet the market is quickly growing and will continue to do so. Indeed, it must: trillions of dollars are needed to effectively address the critical social and environmental challenges that face the world today, such as those outlined in the Sustainable Development Goals.

In order to meet global need, much more capital will need to be unlocked for impact investing — but there is good reason to be optimistic. One in four dollars of professionally managed assets (amounting to USD 13 trillion) now consider sustainability principles. There is great potential for these investors, who have already aligned their capital with their values, to more intentionally use their investments to fuel progress through impact investments. The growing consideration of social and environmental factors in investing is also a signal of a larger shift in the global financial markets — an increasing number of people are recognizing that their money should do more than just make more money. Their investments can — and should — also seek to fuel meaningful, sustainable social and environmental impact.”

 

 

This is a very interesting study and provides a benchmark to measure future growth of impact investing. Globally it is a large market and it is sure to grow further.

Likewise, impact investing is gaining a growing presence in New Zealand. Based on international evidence, there is a strong demand from investors for investments that generate positive, measurable social and environmental impact alongside financial returns.

Fort those wanting more background on Impact Investing this report posted by the Ākina Foundation maybe of interest (Ākina Foundation Impact Investing Sept 2017).

 

Happy investing.

 

Please see my Disclosure Statement

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