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The biggest responsible investing myth debunked

Nov 02 2018 10:08

By Jon Duncan, Head of Responsible Investment, Old Mutual Investment Group

Contrary to popular belief, investors are not giving up upside performance when prioritising companies with a better environmental, social and governance (ESG) record.

Responsible Investing is rooted in an understanding that how we invest today determines the quality of our future. Simply put, if we continue to invest in unsustainable companies that erode public trust, pollute the environment and drive inequality, we should accept that this is the kind of future we will bestow on our children.

Responsible Investing continues to gain attention from the investment community because companies with better Environment, Social and Governance (ESG) practises can, and do, drive better investment performance. At its heart, this latter dimension is a focus on the understanding that sustainability is a macro thematic trend that is fundamentally reshaping the competitive landscape across all sectors. Research from Harvard Business School in 2014 evidences that companies with good sustainability practises, versus their industry peers with poor sustainability practises, produce both market and accounting based outperformance. The core myth associated with Responsible Investment is that companies that focus on ESG issues reduce returns on capital and long-run shareholder value. The reality as evidenced by both academic and industry research is to the contrary: companies committed to sound ESG practises show specific measurable attributes such as lower cost of capital, better resource efficiency, stronger innovation, lower staff turn, stronger social licence to operate and better access to markets. All attributes that can and do influence competitive advantage and longer-term performance.

RESPONSIBLE INVESTING IN LISTED EQUITIES

Both the “ethical” and the “maximising risk-adjusted returns” dimensions of responsible investing have resonated with the retail investing community. In line with global trends, there is a growing number of local retail investors, as well as financial advisors, who are realising that the outperformance of companies with higher ESG scores speaks for itself.

There are three broad approaches in the listed equity environment for a domestic retail investor to consider:

1. Traditional equity products that incorporate ESG issues.

This means the fund manager makes a commitment to factor in and integrate ESG issues in their investment strategies. This includes taking their role as custodians of clients’ capital seriously by engaging with investee companies through a ‘Responsible Investment’ lens and ensuring their proxy voting aligns with the commitment to a sustainable approach to investment. The fund manager should also be able to indicate how they have considered and championed ESG issues in their investment process through transparent communication, i.e. reporting. This approach should be a minimum consideration for all investments and investors can apply this equally to local and international investment funds, assessed through fund fact sheets.

2. Thematic-styled equity products that build portfolios of companies that are part of the sustainable economy (i.e. low-carbon, resource efficient and socially inclusive).

 

Funds using this approach can be single-themed funds focused on renewable energy, sustainable mobility or water. They can also cover a broad range of themes across the ‘green economy’ with specific exclusions around key issues, for example coal or tobacco. This approach is currently difficult to apply in the local market as there are not many listed companies with revenue directly linked to core sustainability growth themes. It can however be successfully applied at an emerging or developed market level, and there are several investment firms that offer compelling products in this category. This is a viable option for investors who believe in the long-term growth theme of a sustainable economy. 

3. Index or active quant funds that systematically capitalise on ESG data asymmetry.

This approach relies on the growing body of company level ESG data that is available through a range of service providers, for example the MSCI. This ESG data is leveraged to create ESG indices (indices that give exposure to companies with a strong ESG stance) or used in innovative active quant investment strategies. There are already several ESG index products available both locally and globally that can offer retail investors market-like returns by holding a basket of companies that are measurably better when considered on an ESG basis. Coupled with low costs, these passive investment products can offer investors an attractive starting point.

For domestic equity investors that have an interest in Responsible Investing, two viable options exist – either select a traditional fund that has integrated ESG into its investment and ownership decisions or look into ESG-led index-tracking products.

Not covered in this article are approaches that involve negative screening based on ethical or faith based values. Such approaches can be employed, but may conflict with maximizing risk adjusted returns (which is of course a perfectly reasonable outcome if values alignment is the primary goal).


ABOUT JON

Jon has over 20 years of experience in the field of sustainability research and engagement and leads the Responsible Investment Programme at Old Mutual. His focus is on driving the systemic integration of material environmental, social and governance (ESG) issues across Old Mutual. Jon also heads up the Sustainability Research and Engagement function at Old Mutual Investment Group and advises on ESG integration into investment solutions.


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