Colour me green

As South Africa was in the midst of Apartheid, it was met with a variety of global responses, among them the rise of the conscience-minded investor.

‘Ethical investment’ was the catch cry of the mums and dads wishing to bring their values and social concerns to their investment decisions.

“People didn’t want to invest in South Africa when it was for Apartheid. They didn’t want to invest in companies associated with the Vietnam War,” according to Trevor Thomas, general manager of Ethinvest, a financial planning practice focused on ethical investment.

It seems, then, it was in the heady days of social and political change that ethical investment was born. Over time it has inevitably shifted and reshaped, adapting itself to meet changes in social, environmental and corporate settings. Today, traditional ethical investment has arguably been relegated to sibling status in a mainstreamed ‘responsible investment’ universe.

“Ethical investment certainly describes the attitude of investors, but fund managers increasingly, as environmental and social concerns grew, and corporate responsibility grew, started to look for other ways of talking about evaluating the risk around investments,” Thomas said.

Indeed, ask investors what responsible investment means and you will receive a variety of responses: ethical investment; socially responsible investment (SRI); risk management; and, of course, environmental, social and governance concerns (ESG).

This much, however, is clear: the ethical client invests according to their beliefs and values; the responsible investor asks what issues are likely to drive investment returns, taking into consideration environment, society and governance.

“Responsible investment is about understanding the risks and rewards associated with investment. And what it is, essentially, is to take a wider view of what risks and opportunities are facing companies, looking not just at the short term but also medium and long term,” said Helga Birgden, Mercer’s head of responsible investing.

It is easy to see where the waters might get muddied; less opaque is just how expansive the concept of responsible investment is, and how deeply intertwined are the ethical and responsible investment worlds.

Amanda McCluskey, head of sustainability and responsible investment at Colonial First State’s Global Asset Management arm, was quick to point out that it is very much an evolving area — and that ethical investment and ESG are far from being one and the same.

“I see them as two very distinct investment styles, and nothing drives me crazy more than when I see these surveys that say ESG funds underperform or outperform. Because mainstreaming ESG is not about having an ESG fund or ESG thematic.”

Lonsec senior investment analyst — managed funds, Steven Sweeney suggested the concept’s evolution has been driven by the institutional market, with ethical funds a small, almost marginalised sector in the retail space.

“I think what we’re seeing, looking at the sector for the last two years, is that there’s more and more sort of mainstream

Australian equities, not so much on the global side, but on the Australian equities teams that are incorporating sustainability issues, or ESG analysis into their mainstream company analysis. Really that’s probably because they’re concerned about the risk side of the equation.”

However, Paul Harding-Davis, head of distribution at Australian Ethical, which deals solely in ethical funds in both the retail and institutional spaces, argued that ESG was actually developed by ethical fund managers, implying the distinction is fairly superficial.

“It was, in fact, one of the core tools for applying what were, and still are to a degree, ethical issues. So we don’t see it as much of a distinction as is being drawn by some out there,” he said.

Harding-Davis acknowledged that it was a differentiation being “bandied about in the industry”, but that a number of people, particularly on the institutional side, don’t agree with it.

“They see it more as a spectrum, and you’re somewhere along that spectrum in terms of how, or the extent to which, you incorporate environmental, social and governance factors,” he said.

But McCluskey was adamant on the difference between the two: “Socially responsible and ethical funds are quite valid investment choices for individuals who want to invest in line with their moral or ethical beliefs. But what we see as the importance of ESG issues is that they can potentially drive company value.”

Robust argument aside, Harding-Davis said he found interesting the contention that ESG investing is not ethical investing.

“They’re using ESG to look for material risks across the portfolio in particular, and to an extent, sometimes opportunities around those issues. The thing about ethics is that of course they do have a material, financial impact to them, you just don’t know when it’s going to happen,” he said.

“You could look at the litany of various failures around the world, whether it’s a sub-prime issue, whether it’s specific companies. And while everything’s travelling along smoothly, ethics don’t have an impact. But when it does have an impact, it’s often pretty nasty because things drop off a cliff.”

Michael Walsh, head of strategy and development at dedicated ethical funds manager Hunter Hall, said that investors may have ESG concerns in their approach to ethical investment, but governance is very much part of the mainstream.

“I think, importantly, our supporters are financial advisers. And financial advisers tell us the way they translate investor concerns about ethics is in talking about how to avoid certain types of industries, and that’s what people are most comfortable with. So they don’t want to be involved in gambling companies. And historically, for example, we still have a ‘no uranium’ policy.”

Importantly, Walsh noted, their investors go to them partly because they want to make an ethical investment decision, so to rename it and focus only on ESG with no screens would be a mistake.

“It’s not a concept that individuals relate to very easily. I think the ESG concept is a very useful way of encapsulating a number of intangible factors that are inherent in successful companies.”

The concept is certainly gaining traction.

In 2005, the United Nations developed its Principles of Responsible Investment (UNPRI) in consultation with some of the world’s largest institutional investors, an initiative that has since attracted over 550 signatories worldwide.

“I think it’s a reflection of the fact that these sorts of conversations are now much more mainstream,” Thomas said. “And so I’d say the UN is kind of a follower in that regard. I don’t think it has any impact whatsoever at the level of individual investors that I speak to.”

Who’s being a responsible investor?

Given the current financial setting in which they are operating and the strong trend towards environmental issues (namely carbon trading and climate change), it seems reasonable to expect fund managers to be doing their utmost to avoid becoming the next cautionary tale. But are they becoming more responsible investors?

“I think we’re in the middle of a global financial crisis that’s got its roots in some of the things that responsible investors are suspicious about, like self-regulation, greed and things like that,” Thomas said.

“So there’s a sense in which people who have been looking for responsible investment are disappointed by what they see in terms of unethical behaviour … in terms of the global financial crisis.”

Birgden argued that some important inroads have been made and the work is being done.

She recently presented the findings of a study conducted by Mercer on fund managers’ ESG reporting. On how ESG was taken into account in the management of a fund, the majority of respondents pointed to a consideration of both risk and opportunity. Those only looking at risk comprised 5 per cent of respondents, 9 per cent looked at opportunity alone, and 35 per cent took neither into consideration

For Birgden, the results are proof of increased attention to ESG, a trend also recorded by Mercer in its ratings process. Since 2008, the researcher has rated approximately 1,700 investment managers globally, not only on their financial performance, but also on their ESG capacity.

“There are names that stand out. I mean it’s true to say that our ESG ratings are ESG 1 to ESG 4, with ESG 1 being the best and ESG 4 being the worst. And I would say that it’s a relatively small percentage that Mercer awards an ESG 1 to.”

Without naming any managers, Birgden said there are some good examples of well-known firms.

“They tend to be firms that incorporate ESG through a bottom-up stock selection research process. So they tend to have their analysts looking at ESG issues in the fundamental stock analysis process. They look for … investment ideas in relation to ESG issues. They bring it into their portfolio’s construction, they take active bets in relation to effectively, for example, hedging against climate change (so responding to the threat of climate change), and bring it in through their business and in a comprehensive way, not just quarantining these ideas in a specialist fund.”

A change in climate

Hot on the heels of governance and risk in a weak market is the environment, whether it be a focus on sustainability or a consideration of the investment opportunities arising from environmental issues.

In fact, Walsh said ESG is a good way of encapsulating the fact that the cost to the environment of corporate behaviour is being accounted for, in particular if, one day, we have a carbon scheme.

“We also are very conscious of the fact that the world is learning how to price the cost of the environment into its economy, and also how to allocate capital to solutions to that. So we think there’s money to be made out of this environmental adjustment process as well.”

McCluskey agreed that the environment is front of mind in the industry, but said it’s mostly about carbon trading.

“There are other environmental issues in terms of the physical impacts of climate change, other sorts of environmental legislation and other environmental performance metrics. Water use, for example, is still really important. But there’s a huge focus on carbon.”

Birgden referred to increased environmental risks and opportunities facing companies, including the inescapable “mega theme of climate change”.

“I think an example of that is the fact that carbon will have a price, it will affect the bottom line of companies,” she said.

The ethical investor’s performance

In March, investment researcher Regnan said companies with an ethics and culture policy, and risk identification or oversight, have made money, pointing to the relevance of ESG from a fiduciary perspective.

“It’s always an issue the industry has to grapple with: do investors forgo alpha by incorporating greener issues into their investment decision?” Lonsec’s Sweeney asked.

“When we’ve looked at this issue, it’s been surprising that — and the industry’s got its own research —generally the funds that Lonsec rates have held up very well against mainstream Australian equities.”

Harding-Davis said the downturn has led to a noticeable difference in performance across Australian Ethical’s equities-based funds and the balanced fund.

“We have quite markedly outperformed, so that is a very good story. The performance of other responsibly invested or ethically invested funds varies, and depends a little bit on their style and their nature.”

Hunter Hall has gone on record that it didn’t have a very good six months to December: “In fact, not good at all,” Walsh said.

“But if you look at our more recent returns they’ve come back very strongly. And, again, if you look at our numbers compared to any mainstream peer group for three years or more, which is a reasonable time horizon, we’re one of the top performers.”

According to Walsh, Hunter Hall is an “active investor”, typically investing in small, undervalued companies, often buying significant positions in them — an approach that has proved favourable.

“We do a lot of research to find those with a strong investment, so we want to find a good business that’s cheap.

“So we may find stocks that are sort of strong on ESG factors, where we see there’s a really strong investment thesis.”

As for the broader thematic of responsible investment in funds, Ethinvest’s Thomas said responsible investment funds have not been significantly outperforming or underperforming their peers in traditional investments.

“More broadly, we’re in a fairly significant crisis around the environment and climate change, which also has significant impacts on long-term investment returns. And we think that those companies and investment managers that have started to think about the implications of living in a carbon constrained world … are actually those who are likely to do better over the medium to long term by thinking about it first.”

Thomas believes that these funds are not likely to vary too differently in the upswing or the downswing.

“The longer the time frame, the more we think that [responsible investment] themes will be absolutely mainstreamed and will become real determinants and drivers of performance. So companies that treat the environment like a toxic waste dump will find that they are increasingly less able to compete.”

Driven by risk

No matter what the meaning of responsible investment, it’s fair to say the concept is mainstreaming, and as a result, Thomas said, broadening and potentially getting shallower.

And risk management, according to some, is the real area of concern, as companies will be increasingly driven by risk — to reputation, of litigation, and of changes in legislation — not by a fundamental core commitment to environmental sustainability.

“The responsible investor comes in and says, this is the legislative environment in which we’ll be operating, these are the risks, how do we manage and mitigate those risks?” Thomas said.

“I think the key point is that it’s certainly true that managers are increasingly taking environmental, social and governance issues into account in terms of risk management, but also as a genuine source of alpha,” Birgden said.

She added that the impact of weak governance and social issues are increasingly part of manager risk management.

“I suppose what we do see is that there are some very sophisticated models which are being used by some investment managers when it comes to risk and they do incorporate what we call ESG issues.

“Whereas other managers might take these kinds of things into account at a sector level or at a strategic level, they might consider risks from a strategic point of view, but not in a very systematic way.”