Hauling ESG from the periphery

Responsible investment and investment returns are no longer mutually exclusive, and industry experts warn that those who do not get on-board risk a day of reckoning over the long-term, Malavika Santhebennur finds.

A survey of investors five years ago on the importance of environmental, social, governance (ESG), and ethical considerations in portfolio management might have garnered tentative responses of "maybe", "sometimes", or "not often".

Increasing awareness and coverage of issues like climate change, and specific incidents of environmental disasters around the world caused by human activity have brought ESG issues into sharper focus in the investment world, where investors have now deemed it as a critical consideration.

However, an underlying myth has lingered that because investing responsibly involved screening and reducing the investment universe, logic would dictate that this would compromise on returns.

Colonial First State Global Asset Management head of responsible investments for the Asia Pacific, Pablo Berrutti, said that the quality of the investment manager determined performance, rather than performance being predicated on whether a manager used a responsible investment product.

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"That's unfortunately the myth that will not die, but it is a myth that you have to sacrifice returns to invest responsibly," he said.

"Significant bodies of research show that by incorporating different responsible investment approaches, and it doesn't matter whether they are excluding companies or you can positive screen or just integrating ESG factors into regular investment processes, all of those types of funds can still perform as well or better than their peers."

Trends and figures

That body of research included the Responsible Investments Association Australasia's (RIAA's) Responsible Investment Benchmark Report 2016, which found that as at 31 December 2015, responsible investment comprised $633.2 billion assets under management (AUM), which made up 47 per cent of all assets professionally managed in Australia. This compared to $629.5 billion AUM in 2014, which comprised of 50 per cent of total AUM.

RIAA chief executive, Simon O'Connor, said that in the institutional end of the market, ESG, and corporate governance issues that used to be considered as peripheral non-financials were now considered financially material to institutional markets.

"Really, it becomes very hard to have a full grasp of the changes in valuations in investment markets without understanding these E, S, and G factors as well. Now we have the vast majority of the industry that gets that," he said.

The data also showed that the average responsible investment fund (between 16 to 30 sampled funds) in Australian share funds returned 8.3 per cent over one year, 12.3 per cent over three years, and 10.5 per cent over five years.

This was compared to the large-cap Australian share fund average of 3.2 per cent over one year, 9.2 per cent over three years, and 6.5 per cent over five years.

"I think that's been helped considerably in a sense by having seen a number of very clear textbook examples of listed companies that have had some pretty detrimental impacts on
their share price from mismanaging these environmental, social and governance factors," O'Connor said.

In 2015, the US Department of Labor updated its guidance to trustees of pension plans and changed its fiduciary duty rules allowing managers to integrate ESG strategies, with the guidance acknowledging that ESG factors "may have a direct relationship to the economic and financial value of an investment".

PIMCO portfolio manager, corporates and financial, Alex Struc, said that historically the US questioned whether sustainability may have been in conflict with fiduciary duty for asset managers, because the US legislative framework was such that in order to prove custodial fiduciary duty, asset managers needed to show as much diversification as possible.

"As ESG developed through SRI negative screening and exclusions, it's mathematical that once you exclude certain industries, some managers may conclude that it actively diminishes your diversification," Struc said.

However, the latest communication from the US Department of Labor "effectively addresses the issue, giving a green light to asset managers to incorporate ESG as part of a diversified portfolio", Struc said.

O'Connor said Australian industry bodies were seeking similar clarification from the Australian Prudential Regulation Authority (APRA) to put any myths to bed on the conflict between sustainable investing and returns.

The RIAA report also found that some advisers were directly managing investment portfolios for clients under responsible investment policies.

There was an increased focus on responsible investment from advisers due to rising interest from charities, family offices, high net worth individuals, and other retail investors. It quoted the Ethical Advisers' Co-operative, which surveyed their 18 specialist financial advisers in February 2016, and found their members managed $958 million in funds under management and advice.

Philanthropy and charity

Perpetual Private's head of investment research, Kyle Lidbury, said the firm's adviser force was structured in such a way that it had specialist advisers who specialised in not-for-profit philanthropic work.

He said clients who invested in philanthropic funds and trusts were driving the push towards responsible and ESG investing.

"Whenever we go out and pitch and tender for business, there's always a question on the questionnaires: ‘do you have a responsible investment policy, how do you approach this part of the portfolio? How do you incorporate that into your portfolio?'" he said.

While data was scarce on the demographic that was most keen on responsible investing, global research from Scorpio Partnership and FactSet found 61 per cent of investors aged under 35 wanted their investments ESG screened, compared to 29 per cent of those over 55. Almost half of those 55 and over said a socially responsible process "is nice to have, but not essential".

Of the $13 billion in funds under advice in Perpetual Private, $2.5 billion of that was in philanthropic investments. This segment included trusts, and trustees with private ancillary funds, public ancillary funds, estates with charitable purposes or in perpetuity trusts, and private charitable trusts.

According to Lidbury, this segment took a greater interest in what he called "leading edge" impact investing rather than just ESG investment or responsible investment, with investors not just focusing on investments that provided a market return, but also a positive social outcome.

"This has been quite attractive because obviously in a low income world, the returns off endowments and portfolios are not what they've been and if philanthropists can actually leverage their actual portfolio to provide a social good as well as make a return, that's where we're seeing a lot of interest," he said.

The RIAA report defined impact investing as targeted investments that looked to tackle social or environmental issues while generating positive returns. This could include community investing in projects with a clear social purpose.

Lidbury cited social benefit bonds as an example where a government and a charity established bond programs where the payment of the bonds was dependent on the charity being able to achieve social impacts, and gave a project to tackle homelessness as an example.

"The government sets targets around the charity achieving certain targets on homelessness, taking kids off the streets, getting them enrolled in training, etc. and then the Government makes payments on those securities because they know that with ‘x' number of kids off the streets, they won't have to spend as much on welfare for our programs," he said.

Be patient for the long haul

The funds management arm, Perpetual Investments' Perpetual Wholesale Ethical returned 6.77 per cent over a three-month period (fees quoted are before management fees and tax), compared to the S&P/ASX300 All Ords benchmark of 7.02 per cent and the S&P/ASX200 All Australian benchmark of 6.83 per cent, according to the Mercer Investment Performance Survey of Australian Shares ending July 2016.

However, over a five year period, the Perpetual ethical fund returned 18.45 per cent, compared to the S&P/ASX300 All Ords benchmark of 9.38 per cent, and the S&P/ASX200 All Australian benchmark of 9.4 per cent, according to the Mercer survey.

Many other socially responsible investment (SRI) funds in the survey showed more robust returns over the longer term, compared to the benchmark.

Industry executives concurred with this theory, with Local Government Super (LGS) chief executive, Peter Lambert, saying the fund's Australian sustainable shares option, which began three years ago, outperformed the ASX200 by two per cent over three years. RIAA's report showed that LGS held over $7.2 billion in core responsible investment out of $9.5 billion of its assets.

"We're quite comfortable that we're starting to get long-term figures that show that responsible investment does not necessarily mean a reduction in returns and really we feel that responsible investment will become increasingly mainstream as it becomes generally accepted that the myth that you do jeopardise returns by investing in that way is debunked," Lambert said.

The superannuation fund's sustainability investment has added around 39 basis points across the entire portfolio over the last financial year and six basis points per annum over the last three financial years.

Lambert said while LGS Super excluded investment in coal due to climate change concerns, it had re-admitted nuclear energy back into the portfolio where it was originally banned. While uranium would play a greater role in the firm's portfolio mix, the firm was also looking to ban all fossil fuels.

"I think in our social investment policy you may therefore find all oil companies, for example, will get excluded in addition to coal," Lambert said.

"We started on coal because clearly it was the heaviest carbon emitter. But we feel that other industries are going to get affected and it may not happen today or in the next couple of years but you need to be ahead of the curve on this," he said, adding that while the resources sector was cyclical, the firm was enforcing a blanket exclusion.

A focus on society

In terms of social impacts, Australian Ethical has adopted a policy where it would exclude companies that have detrimental health impacts on society. The company refrains from investing in firms like Coca-Cola and Domino's, as there was a lack of responsible consumption of the products sold by these companies.

Head of ethics, Dr Stuart Palmer, said: "We think it's challenging because obviously small amounts of fast food and sugary drinks are not a major health issue but we have a major issue society-wide with over consumption of those types of foods".

"So while that remains a problem, [and] we don't have responsible consumption, we don't have responsible marketing of those sorts of products, we won't invest in companies which manufacture them."

The firm, which has operated for 30 years with a responsible investment strategy under its own ethical charter, also refrained from investing in Apple due to its tax avoidance track record, where it transferred most of its profits to Ireland.

"There's certainly no shortage of issues for us to think about. We include all of that in our screening but then the question is, on the advocacy and engagement front, where do we feel we can have the most impact?"

The firm's ethical charter consisted of 23 principles: 12 positive elements, which the firm endeavoured to support, and 11 negative elements which it excluded from its portfolios.

Palmer also said Australian Ethical refrained from investing in three out of the four big banks due to their track record of lending to fossil fuel industries, but it did invest in Westpac as it found the bank had been a "sustainability leader" when looking at new fossil fuel lending trends, and investing in renewables and energy efficiency.

"We still think the big banks have an important role to play, for example in shifting capital to sectors like renewable energy, helping us transition to a zero carbon energy system," Palmer said.

Sound the alarm bells

While debate has raged around whether responsible investing compromised on fiduciary duty in the past, Struc warned that companies that did not plan ahead for the effects of climate change, culture and conduct, and social footprint risked leaving investors vulnerable.

Companies would scramble to compensate, leaving the cost of risk (spread in the markets represented through debt or equity investments) vulnerable. Companies that failed to factor in sustainability into their business model would face heavy costs.

"The effects of climate change could be coming over the long-term; it could be anywhere between three, five, 20 years."

"But often it comes unannounced. When climate change effects manifest themselves, it's too late for the financial industry to deal with it. This was pointed out by Mark Carney [governor of the Bank of England] in his speech at Lloyd's of London in September last year," Struc said.

He added that the growing demand for sustainable investing would see a corresponding growth in sustainable investment products.

"The awareness of incorporating sustainability is actually echoed not only through clients but asset managers, and regulators as well. It's a long-term transition," Struc said.