Financial planning and responsible investment - the new paradigm

There has been a growing interest in responsible investments over the past year, particularly among retail clients. Climate change and rising sea levels are just some of the factors financial planners need to be aware of when recommending ethical products to retail clients, writes Janine Mace.

When a client arrives at your office and wants to talk about buying an investment property down the coast for their retirement, what do you think about? 

How does it fit into the asset mix in their portfolio? Where are you in the property cycle? How will they fund the purchase? 

How about rising sea levels?

While it is not an issue likely to be at the top of the list, it certainly should be on the list if an adviser is doing the job properly. Many coastal properties in Florida and around the Gulf of Mexico are now considered uninsurable by large insurance companies due to the environmental risks they represent.

According to Responsible Investment Association Australasia (RIAA) executive director, Louise O’Halloran, climate change is an issue advisers cannot afford to ignore.

“The regulatory landscape is leaning heavily towards financial planners taking responsibility for the risk management of their client’s investments,” she explains.

Recent events such as the BP oil spill in the Gulf of Mexico, the Tepco nuclear disaster in Japan, and the phone hacking scandal surrounding News Limited have all highlighted the importance of environmental, social and governance (ESG) risks on the long-term investment performance of corporations.

O’Halloran believes the changing regulatory environment means at the very least advisers need to consider the relevant ESG risks before investing. “These issues should be taken into account, whether the client asks or not.”

Russell Investments director of consulting and advisory services, Greg Liddell, made a similar point in a recent interview with Money Management. “The risks associated with climate change are such that if you make certain investments without educating yourself on those risks, then you are probably negligent in your fiduciary duties and responsibilities.”

He believes the example of the impact rising sea levels could have on Australian coastal property illustrates the point well. “If you are making property investments in those areas without considering those risks, then that is not a prudent thing to do.”

Liddell went on to note institutional investors have a heightened awareness of the risks around issues such as the insurability of coastal properties when it comes to making long-term investments. “Institutional property managers are very aware of that but I’m uncertain retail investors understand the implications of that.”

Implications for portfolios

It is not just the risk of rising sea levels that advisers cannot choose to ignore, explains Australian Ethical managing director, Phillip Vernon. “If you take the view that the pricing of carbon is going to happen, then you need to consider having a portion of a client’s funds invested to deal with that change.”

This is exactly the rationale outlined in Mercer’s Climate Change Scenarios – Implications for Strategic Asset Allocation report, which recommended large pension funds around the globe consider reorienting their asset allocation to ‘climate sensitive’ assets to help mitigate risk and capture new opportunities.

With the Mercer study finding climate change could contribute as much as 10 per cent to investment portfolio risk over the next 20 years, interest in responsible investment approaches which identify, measure, and incorporate ESG risks into investment decision-making has never been higher.

This is an area investment professionals increasingly see as mainstream, according to Perpetual’s manager, responsible investment and sustainability, Pablo Berrutti. “These issues are not going away and how companies are considering them will be increasingly important to investors.”

O’Halloran agrees responsible investment and ESG considerations are now far removed from traditional ethical investment funds which focused on values-based investing or screening out gaming or nuclear stocks.

“It is not about screening out a couple of areas that are harmful. We are in the 21st century and massive issues dominate due to things like resource scarcity. They will increasingly dominate the investment landscape in the future,” she explains.

“The investment community is learning to look at risks at the incremental stage, rather than when they are catastrophic. We are now trying to put these signs into our financial modelling.

“These are investment and measurement techniques – not a new breed of investment products,” O’Halloran says.

She believes recent events and their impact on the companies involved have demonstrated the importance of ESG risks to the returns investors receive. “It has shown the need to become better at measuring and including risks in the investment management framework.”

Reducing investment risk

O’Halloran believes the investment landscape is changing dramatically as investors search for investments that offer less risk. 

“These are not themes in responsible investment but trends in investment management – and they are increasingly being embraced. It is a change in the DNA of the investment world,” she explains.

“Responsible investment is about finding more information and better information about company value in the 21st century.”

This approach to ESG investing is becoming increasingly common in other countries. The European Sustainable Investment Forum’s (Eurosif’s) 2010 High Net Worth (HNW) Individuals and Sustainable Investment Study found sustainable investment was now largely perceived by the European HNW population as a financial discipline (rather than an investment style) and specific knowledge of ESG issues necessary for successful investments.

As William T. Mills III from Highland Good Steward Management (one of the report supporters), noted: “ESG integration is a financial discipline and not a standalone product; the industry must work with the best asset managers to fully integrate ESG policies across a multitude of asset classes, strategies, and products.”

It is a view endorsed by many large Australian institutional investors such as the big industry superannuation funds. 

The SuperRatings 2011 Infinity Report found the strongest factor driving the adoption of sustainable behaviour in superannuation funds was the desire to reduce exposure to ESG risk. The study found 53 per cent of fund respondents said responsible investment decisions were incorporated into their decision-making process at the investment committee level, with 61 per cent stating corporate governance was the most important or a major factor when selecting investments.

The growing acceptance of responsible investment practices is being backed by fund inflows. The 10th annual RIAA Benchmark Report found a 10 per cent increase in managed responsible investment portfolios in 2009/10, which saw total Australian portfolios hit $15.41 billion.

According to RIAA, the finding “reaffirms that taking environmental, social and governance issues into account has become best practice for those looking to improve investment performance in the short and long-term”.

The report also highlighted the sector’s continuing good performance. It found the products had outperformed the average mainstream fund over one, three, five and seven years for both Australian and international shares in 2009/10. Balanced growth managed funds outperformed mainstream funds over five and seven year periods.

O’Halloran believes performance is no longer an issue. “Responsible investment funds in Australia have outperformed all of their mainstream counterparts.”

Even the global financial crisis (GFC) seems to have done little damage. “The 2010 results include the GFC and responsible investment has done very well compared to mainstream funds,” she notes.

Vernon agrees: “As far as the ethical sector goes, our portfolios tend to be defensive by their nature, so they have tended to perform well during the GFC.”

Ethical lives on

Although ESG investing has grabbed most of the attention, ethical investing still remains a key element within the space. The key difference is ESG methodologies tend to focus on the business case for an investment and creating value – not values.

“ESG integration is about taking a risk based approach to investment,” Berrutti explains.

“For example, the News Limited situation shows the need to consider these risks in the price you pay for a stock, but for ethical funds, the governance issue is so great they will not buy it at any price.”

Ethical funds are not even always about ‘clean and green’. For example, some Christian funds are based on Biblical values, while Sharia funds exclude products related to usury, blood products and alcohol.

Vernon remains convinced there is a market for ethical investments despite the growing interest in ESG disciplines. “We still see the interest in ethical and believe the interest is actually growing,” he says.

“Ethical investment unashamedly uses a values based investment approach. Ethical investment offers a distinct point of difference.”

Berrutti agrees ethical investing holds strong appeal for some investors. “There will always be a place for ethical investments. There will always be people looking to buy their values. Our customers want to invest their values, and will continue to do so for many years.”

O’Halloran agrees: “The market will always want products that take ethical and moral issues into account.”

However, even the traditional ethical investment approach of using negative screens is evolving. “Ethical is becoming increasingly sophisticated and is no longer just about blanket negative screens,” Berrutti notes.

Drive for impact investments  

Although interest in responsible investment is growing, several developments are likely to give it further impetus. For example, the standard of company reporting on ESG issues is receiving closer attention.

In August, the Financial Services Council and the Australian Council of Superannuation Investors released the ESG Reporting Guide for Australian Companies, while the International Integrated Reporting Committee is due to release a discussion paper in September on how sustainability measures can be integrated into company reporting.

“Better reporting allows for better decision-making, and so, for the responsible investment community who have long lamented the lack of company reporting, this represents significant process,” Berrutti explains.

“Both initiatives demonstrate a push by mainstream investors and other stakeholders for increased reporting by companies on their non-financial (ESG) performance.”

Shareholder interest and involvement in company activities through AGM resolutions is also growing.

“There is increasing advocacy and putting resolution to companies about their climate performance. Increasing shareholder activism has occurred overseas, and we are seeing an increasing number of shareholder resolutions here,” Berrutti notes.

Vernon agrees this is a growing trend. “Our Climate Advocacy Fund launched last year builds on the active ownership principle of responsible investment and draws on overseas trends from the UK and the US,” he explains.

“Advocacy with companies is becoming a large trend in the market. It supplements other investment products for retail investors keen to take an active role in engaging with larger companies.”

Developments are also occurring in local governments. Both the Melbourne and Sydney City Councils have introduced legislation making it easier for property owners to upgrade their buildings to meet new energy and environmental standards. The costs are then passed onto tenants through their rates, allowing the expense and benefits to be shared between owners and tenants, Berrutti explains.

At the product level, interest in broadly based thematic funds is rising. “There is a lot more interest in funds based on macro-investment themes, such as clean technology, food and soft commodities,” Berrutti says.

He believes this interest has been reinforced by the Mercer Climate Change Scenarios study. “It generated a lot of interest in the potential of thematic funds based on themes like resource scarcity.”

Another international development is the emergence of so-called ‘impact investing’. In the UK, the Government plans to unlock the investment needed to deliver a low carbon economy by proposing a Green Investment Bank and the creation of green ISAs (Individual Savings Accounts), which would direct investment to ETFs and other retail vehicles tracking green and low carbon indexes. 

“The idea is to de-risk the funding of private investments,” Berrutti explains.

The Australian Government’s proposed $10 billion Clean Energy Finance Corporation (CEFC) is a similar initiative. It claims the CEFC will “drive innovation through commercial investments in clean energy through loans, loan guarantees and equity investments”.

According to O’Halloran, the concept of impact investing is being applied in a number of areas. These include developing micro-enterprises which fund micro-financing and assisting companies working to produce affordable housing or distributed solar power.

“The idea is to create and seek out innovative new investment models that directly stimulate companies that solve big issues,” she explains. 

“The question now is how to develop pooled investment vehicles from these ideas.”