Why ethical investment is no longer a hypothetical

With corporate blow-ups becoming commonplace and ‘short-termism’ dominating investment markets, ESG issues are more relevant than ever. 

The notion that the world we live in is completely divorced from reality may be a little disconcerting for some readers.

But for those of us attempting to navigate modern investment markets – which, thanks to Australia's compulsory superannuation system, tends to be just about everyone these days – it could be closer to the truth than we’d like to believe.

The way Responsible Investment Association Australasia managing director Louise O’Halloran tells it, the lack of widespread knowledge about environmental, social and governance (ESG) risks means markets are perpetually mispriced.

There are effectively two worlds running parallel to each other, O’Halloran says: the “real world”, where ESG risks are under-researched and ignored; and the “shadow world”, where companies are correctly priced.

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“While the real economy and the real world proceed as business as usual, it’s as if the real world is a shadow world and markets are the real world,” she says.

She also points to the endemic ‘short-termism’ of investment markets as one of the factors that has seen an increase in the number of shocks in global markets – such as the BP oil spill, the Tepco nuclear disaster in Japan, and – most pertinently – the global financial crisis.

According to O’Halloran, if ESG risks were better understood by participants in investment markets there would be fewer “shock drops” in share prices when these events occur.

“Let’s say the markets had known of the background activities with BP. Say they'd known they’d accumulated 751 egregious wilful citations by the Occupational Safety and Health Authority between June 2007 and February 2010,” O'Halloran said.

The ethical investor is driven by a zero-tolerance approach to what they don’t like.
 

If that information (which was only obtained after the event via freedom of information requests) had been known by the market, there still would have been a drop in BP's share price following the Deepwater Horizon explosion in the Gulf of Mexico in 2010 – but it wouldn't have fallen from $55 to $27, she says.

Instead, there would be more of an incremental decline – effectively reducing the volatility in the marketplace, O'Halloran says.

The investment industry needs to develop better ESG data in order to accurately determine the long-term value of companies, she says.

“I’m talking three years, five years, 10 years. To the market, those time horizons present massive difficulties. How do you pinpoint a price 10 years out? Yes, it’s hard – but we have to get better at it,” she says.

Fortunately, the quality of research is improving very quickly, says O'Halloran.

Specialist research firms such as CAER are providing investors with quantitative analysis along with a thorough narrative behind the numbers, and there is plenty of sell-side research from companies like CitiGroup and Macquarie that provide stock picks, she said.

She pays particular tribute to the recent work of Bloomberg, which currently provides investors with 250-300 separate ESG data points.

“It's a set of numbers. How many women are on your board? How big is your fleet, is it using more petrol? How much are people flying these days?” she said.

While the quality of information is improving rapidly, O'Halloran says, markets as they currently stand only focus on three things: information in the short term, information that's available to most market participants, and information that is quantifiable.

“When you look at it, you realise how much data falls outside that set,” she says.

Markets need to consider more intangible values, O'Halloran says, like the quality of management, the way companies are dealing with regulatory changes, and how companies treat their workforce.

Getting the facts straight

Looking back 10 years, I’ve been in rooms where you got laughed at when you mentioned environmental issues, or the potential for social issues to constitute investment risk.
 

‘Responsible investment’ tends to be used as a catch-all term for a number of strategies that often have very different starting points.

A strictly ethical approach will limit the universe of stocks a fund manager can invest in, typically screening out “sinful” stocks that profit from things like alcohol, tobacco and gambling.

Socially responsible investments also apply a negative screen, but in addition they look to invest in companies that provide a tangible social benefit.

Finally, there are strategies that operate in the belief that careful attention to environmental, social and governance issues will minimise the long-term risks for companies.

The ESG approach is becoming the standard among institutional investors, and is the subject of a voluntary international reporting regime – the United Nations Principles of Responsible Investment (UN PRI).

ESG factors are beginning to be integrated into most funds run by major institutional players – not just funds that are branded as sustainable or ethical.

Inevitably there is some overlap between funds that take different approaches. The portfolio of a strictly ethical fund may look similar to an ESG fund, but for different reasons.

For example, Australian Ethical cannot invest in gambling companies because they are filtered out by the negative screen in its charter; while AMP's Sustainable Share Fund avoids gambling companies for reasons that are purely related to the bottom line.

“It’s not because we think [gambling] is ethically or morally wrong – it’s because we’re seeing that over time that sector will have to pay for its externalities,” says AMP research analyst Mans Carlsson-Sweeny.

He points out that problem gambling is a big problem in Australia, and the companies which profit from it aren’t paying for the social costs it creates.

“Over time we think the Government will impose more and more regulations, which means an uphill struggle for those companies in terms of earnings growth,” Carlsson-Sweeny says.

“We still align social concerns. But at the end of the day it’s about making money. We’re looking at companies’ long-term earnings,” he says.

Mercer Asia Pacific head of responsible investing Helga Birgden is involved in Mercer's global initiative to evaluate investment managers based on their ESG integration.

“We're not about taking an ethical position,” says Birgden.

“It's very much about analysing the full spectrum of risk that faces an investor,” she says.

As of February, Mercer has assigned ESG ratings to 5,000 investment managers worldwide.

To achieve the highest ranking, ESG1, managers must demonstrate ESG considerations are part of their portfolio construction, and that “they are taking active bets on it”, says Birgden.

Managers who are assigned the lowest rating (ESG4) typically neglect environmental and social issues, and only consider governance issues, she says.

“That's not enough. If you get a tick in governance that doesn't mean that you're integrating ESG,” Birgden says.

Australian Ethical chief investment officer David Macri says his company takes a different approach to typical ESG funds when it comes to selecting stocks.

“We are best described as ‘positive screeners’,” says Macri.

“Every company we invest in has been determined to have some form of positive associated with it,” he says.

Australian Ethical uses research by CAER to construct its investment framework, along with in-house research, Macri says.

He is apprehensive about the idea that ethical investing is subjective in its approach.

“When you look at the facts and you can clearly see what the benefits are of something and what the negatives could be…you can come to a logical decision,” Macri says.

“Ethics is also studied at universities. It’s not completely subjective,” he adds.

The role of financial advisers

To date, the involvement of financial planners in the responsible investment sector has typically been limited to boutique practices that cater to ethical investors.

Trevor Thomas, principal of Sydney-based boutique Ethinvest, begins the first client interview with a fact-find questionnaire that includes a page on “ethical concerns”.

Thomas and his team then go about constructing a portfolio of direct equities that reflects the client’s financial needs and ethical preferences.

The problem with managed funds is that even a firm like Australian Ethical, which has some of the most rigorous screening methods in the sector, won’t be appropriate for every client, Thomas says.

“The difficult thing for [ethical fund managers] is they have to come up with a rule that fits everybody. We’ve got 400 different clients and 400 different rules,” he says.

“The ethical investor is driven by a zero-tolerance approach to what they don’t like,” says Thomas.

That differs from large institutions, which generally take a risk-minimisation ESG approach, he adds.

“They have a materiality clause, which says: ‘If it’s not 5 per cent or 10 per cent of company revenue or company profits, we’re not going to filter it out’,” Thomas says.

In other words, the good stuff outweighs the bad stuff, he says.

While Ethinvest has its own Australian Financial Services Licence, Greenshoots Financial Planning principal Mark Lems operates as an authorised representative of the dealer group Sentry.

Lems admits he has been restricted by authorised product lists in the past, but he has more freedom to recommend ethical funds at his current dealer group.

Like Thomas, his preference is for his clients to be invested in direct equities. Lems selects blue chip stocks that are either 'best of sector' or have strategies and programs in place to improve their practices.

“If a client is going to be a bit cynical about investing in growth markets, then they have to be a bit cynical about the way we live our lives,” Lems says.

“We're not about to go back to the caves.

"If we still want our iPods, the best way to go about it is to try and direct the future a bit better by investing in companies that are on the leading edge or have developed their processes to have a less impactful footprint,” he says.

Finding the right match

But what about financial planners who don’t want to go direct – how should the various products available in the responsible investment sector be used in portfolios?

The research house Lonsec has published an annual review of the sector for “over a decade”, according to senior investment analyst Steven Sweeney.

The 2011 Lonsec Australian & Global Equity Responsible Investment Sector Review covers 10 funds: five ethical funds, two socially responsible investment funds and three ESG funds.

The challenge for advisers is to match their clients up with a fund that aligns with their ethical preferences.

The BT Wholesale Ethical fund is a good choice for clients who are looking for a mainstream equity fund with an ethical overlay to replace a large-cap Australian equities holding, says Sweeney.

The Australian Ethical Larger Companies Trust is best “for clients who are the most ethically motivated and deep in their moral considerations”, Sweeney says.

The Australian Ethical Small Companies fund could be used as a small cap replacement, he adds.

Hunter Hall adopts a lighter ethical screen than Australian Ethical, but its Value Growth Trust and Global Ethical Trust can be used as a satellite alongside a global equities portfolio.

“[The Hunter Hall funds are for investors who are] looking for a bit more of a ‘kick’, are light in terms of their ethical motivation but are concerned about their impact on the environment and society in general,” says Sweeney.

He singled out Australian Ethical for praise because they are “true-to-label”.

“They’ve evolved over the last five years in terms of their investment professionalism,” Sweeney adds.

“Because their large cap fund is investing a lot in healthcare and utilities, it tends to be more defensive than you might think. It's basically an ethical index fund now,” he says.

The returns debate

The question of what effect responsible investment strategies have on returns – both in the short term and the long term – has plagued the sector since its inception.

Ethinvest's Trevor Thomas says some of his clients tell him investing ethically is so important to them that they're willing to sacrifice “a few percentage points” if it means they can sleep at night.

CAER chief executive Duncan Paterson says the conventional wisdom – taught in “portfolio management 101” – has been that “if you restrict your universe by x you’ll reduce your potential return by x”.

But Australian Ethical's David Macri argues that restricting the available universe of stocks can have a positive effect on potential returns.

“The sectors/companies that are being avoided should benefit the portfolio by avoiding the potential ‘blow-ups’,” says Macri.

Thomas points out that Hunter Hall has one of the best performing managed funds in Australia over the last 15 years.

According to the 2011 RIAA annual report, the average Australian equities responsible investment fund has outperformed its mainstream counterpart over one, three, five and seven years.

“It’s never been the case that running an ethical/SRI fund necessarily means you’re going to lose money,” says Paterson.

“The argument that ethical investment equals poor returns – something you sacrifice, the bad-tasting medicine – was put to bed some time ago,” he says.

The more pertinent question, he says, is whether or not ESG integration is correlated with positive returns.

According to Helga Birgden, Mercer has undertaken a number of academic meta-studies since 2007 that show there is no penalty for including ESG issues in the investment process.

“Our view is that ESG either can have a neutral effect, [or as] our study review shows it can have a positive effect on returns. You’re not paying for performance if you consider ESG. In fact it’s the other way around,” Birgden says.

“There’s a misconception that there’s a penalty for thinking about ESG. [Mercer] needs to speak more to our retail investors and our financial planners to correct this misconception,” she says.

Australia leads the way

The 2011 RIAA report shows that over half of the funds under management in Australia fall under the United Nations Principles of Responsible Investment (UN PRI).

This means that approximately half of the funds under management by Australian asset managers fall under UN PRI commitments to ESG integration.

CAER's Duncan Paterson reckons the UN PRI initiative has been a “tremendously positive influence” in the development of the sector.

“Looking back 10 years, I’ve been in rooms where you got laughed at when you mentioned environmental issues, or the potential for social issues to constitute investment risk,” Paterson says.

“Nowadays it’s a given that environmental and social issues do constitute a risk that investors should be mindful of. That’s been a massive achievement from the PRI,” he adds.

But Australian Ethical's David Macri is less enthusiastic about the relatively high number of UN PRI signatories in Australia.

“Without sounding cynical, I think it’s a step in the right direction. It’s an absolute bare minimum that everyone should be doing.

“Does it make all funds ethical or sustainable? Absolutely not,” Macri says.

He adds that investors shouldn’t kid themselves into believing that asset managers are changing their asset allocations as a result of the UN reporting regime.

“What the UN PRI standards don’t do is lead to big changes in investment portfolios for mainstream signatories to the PRI – people are ‘integrating’ ESG into their processes, but their portfolios and overall investment decisions aren’t changing,” says Macri.

Branding and fees

The perception that investment managers are more “responsible” than they may be in reality can be dangerous for consumers, says Macri.

“It is important that consumers are aware of this. Even though mainstream institutions are signing onto the UN PRI, they will not provide the sorts of products that ethical investors will be looking for,” he says.

CAER’s Duncan Paterson agrees.

“If people are signing up to ESG-integration products thinking that they’re in an ethical product they will get upset, and if they’re paying fees on the way in and out of those funds they’ll get upset about the fees they’re paying,” Paterson says.

Fees are a very sensitive issue in the sector – just as they are in the broader investment industry, says Lonsec's Steven Sweeney.

The BT fund is “mainstream” in terms of its fees, as is the offering from Challenger-branded boutique manager Alphinity, he says.

Hunter Hall applies a performance fee, Sweeney says.

“Our view is that provided there’s a hurdle and reasonable base fee, that’s fine. Over time they’ve delivered value for investors. The Australian Ethical funds are reasonably priced,” he says.

But the external research employed by many funds in this sector represents an added layer of cost, Sweeney says.

For example, both Perpetual and Australian Ethical outsource their ethical research to CAER.

“More importantly though: are investors in the sector getting portfolios that are aligned with their choice? They’re probably willing to pay a bit extra for that assurance,” says Sweeney.

Putting the client first

According to O’Halloran, the move towards better ESG research and reporting is about “accepting the world is a different place” – something that will admittedly be hard to achieve given that markets are structured based on “the world that was”.

“The Future of Financial Advice [reforms] have been excellent to play into that hand. It gives a lot of credit to advisers who want to really tap into a relationship about trust and loyalty with clients,” says O’Halloran.

“That’s what responsible investment has always been about. It’s not just a bunch of products. It’s a relationship that is truly trying to tap into what people care about and what they’re concerned about, and to try and minimise their risk exposure. It’s a perfect framework,” she says.