Aiming for a more modern approach

The importance of responsible investing (RI) has increased in recent years and is gradually entering the mainstream investment arena. This trend is irreversible – not just because of high-profile events such as BP’s Deepwater Horizon oil spill, but also because of innumerable others, such as the accounting scandal at Olympus, the collapse of an apparel factory in Bangladesh and ongoing global concerns about the environment.

All of these illustrate how ESG factors can have a significant impact on a company’s share price performance and hence on investment portfolios.

One of the reasons that RI took years to become accepted was the misperception that investing in a responsible way, therefore excluding certain investments, would harm performance by reducing the options available and run counter to asset managers’ fiduciary duty to maximise investment returns. 

However, an increasing number of studies have shown the opposite to be true, that incorporating ESG factors can actually improve the risk-return characteristics of an investment portfolio.

Last year, the US Department of Labor created further clarity on this topic by stating that integrating ESG factors was no longer in violation of one’s fiduciary duty, giving asset managers more freedom to use ESG factors in their investment decision. Integrating ESG factors can – and should – be seen as simply a more complete approach to investing.

In other parts of the world, the attention paid to ESG has also accelerated. Examples include the launch of the Corporate Governance code in Japan as well as the increasing momentum after the COP21 in Paris last year. The latter is driving new regulation in some countries to report on carbon emissions of investment portfolios. Companies that score poorly could have a competitive disadvantage compared with companies that manage this better and have a more sustainable long-term business model. 

Therefore, we would even go one step further and claim that not taking into account ESG factors in the investment process could be seen as a violation of one’s fiduciary duties. Not looking at ESG factors actually leads to an incomplete investment analysis and is, therefore, not in the best interest of clients.

When integrating ESG factors into the investment analysis, it is key to focus on materiality, or those factors that are likely to have a material impact on the long-term sustainability of a company’s business model and, therefore, its share price performance. Such factors include safety standards, environmental impact and access to water in the mining industry; social and labour aspects in the consumer sector; and product liability and bribery in the healthcare sector.

Asset managers and owners could decide to bring in stricter measures, including non-material factors, that provide protection against reputational risk or reflect their values and beliefs. In the last decade, the rise of social media has increased the reputational risks for asset managers, making it all the more imperative for them to integrate ESG factors into their investment processes and potentially reflect their values in their decision making.

Exclusion of companies from the potential investment pool is not the sole objective of RI, however. It is also about finding out which companies do well (or are improving) when ESG factors are analysed. As this realisation is growing, the market is slowly moving away from an approach driven by exclusion-only to a more inclusionary approach.

For the investment management industry, the transition to include ESG factors in the investment process means an expansion of skills for analysts and portfolio managers. This can also be observed by looking at the CFA curriculum, the leading certification globally for analysts and portfolio managers, in which the focus on ESG factors in the investment process has been increasing.

Ultimately, responsible investing and ESG integration is simply a more modern and complete approach to investing. Integrating ESG factors in the investment process is in the best interest of clients as it can contribute to better risk-return characteristics of investment portfolios. Investors who have not looked at ESG factors during their investment process actually have yet to finalise their investment analysis.

Jeroen Bos is head of equity specialties at NN Investment Partners