Ethical/SRIFeb 28 2018

Looking behind the definitions as clients demand grows

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Looking behind the definitions as clients demand grows

Joking aside, while ESG and impact investing are materially different, there are probably as many definitions of socially responsible investing fund providers use which obviously confuse investors. So let’s try to see the wood from the trees.

ESG investing

ESG investing is the integration of ESG criteria into the investment process, primarily focusing on companies’ behaviours rather than their products and services. However, there are two different types of stakeholders using this data leading to two different implementations. 

The first are traditional fund managers who have adopted ESG factors into their financial analysis to evaluate risks and opportunities. Indeed, academic studies all agree on the fact that companies with positive ESG ratings have a lower cost of capital and most studies showed that these companies tend to outperform their peers. 

Following a number of high profile scandals such as Volkswagen, BP and Enron, it is rare for fund managers not to take ESG factors into account as part of their decision making process. 

The second group are fund managers who incorporate ESG screens to design specific strategies that might exclude a particular factor like human rights abuses. These type of strategies are called negatively screened strategies and are often tailored to client specific values. Other ‘best in class’ strategies have been developed, particularly over the last few years by passive fund management groups, and these invest in the best ESG-rated companies across all sectors.

In a recent article, fund manager Terry Smith criticised some of these ESG-screened passive funds for their exposure to tobacco and fossil fuels. 

However, these strategies have not been designed for that purpose. ESG investing should only be seen as the first step towards a more sustainable world. Investors who really want to make a positive difference should look towards impact investing.

Impact investing

This type of investing aims to solve social and environmental challenges by selecting companies which primarily through their products and services create a net positive impact. This approach focuses on finding solutions for unmet needs and increasingly uses the roadmap published by the United Nations for identifying the most pressing issues to be tackled. 

This roadmap comprises of 17 sustainable development goals (SDGs) which are a call for action agreed by 193 countries to end poverty, protect the climate or promote quality education by 2030.

This should not be confused with philanthropy. This approach is very much aimed at maximising both impact and financial returns. Indeed, impact investing is driven by the recognition that finding companies addressing the unmet needs in society represents a structural, secular growth opportunity that can bring wider benefits. 

To avoid risks of green washing, the industry is focusing on the net impact a business is having, not only through its products services but also its operations, often embedding some ESG analysis to their process. The industry is committed to report on that impact achieved not only through case studies but through the use of key performance indicators for the overall portfolio. 

Pioneers like WHEB and Impax within the asset management industry, and others in the discretionary space, are providing evidence in their respective impact reports of the difference that investors can make.

Key Points

  • The difference between the ESG, impact and sustainable investing can depend on how much an investor wants to achieve
  • ESG screening is a  simple way to tilt investments while impact is more aligned to achieving UN goals
  • Fund documents still have a long way to go in terms of disclosing ESG ratings of the underlying holdings

Socially responsible investing

Socially responsible investing can be a catch-all phrase hence the difficulty in defining it, but one can see some differences between passive and active fund management groups. Within the passive industry, socially responsible investing usually means building a portfolio based on ESG ratings and sometimes using a form of exclusion regime.

However, the unwillingness to improve corporate practises through engagement is disappointing, despite the big headlines made by Larry Fink, BlackRock’s chief executive.

In 2016, BlackRock and Vanguard, two passive giants and shareholders, supported more than 90 per cent of the proposals made at companies’ shareholder meetings and voted against most climate change-related proposals. 

While there was some progress made in 2017, engagement is a lot more embedded within the process of actively managed socially responsible funds. 

These groups also tend to go further in their stock selection by combining ESG leaders with companies making a positive impact through their products and services, but the degree of intentionality varies strongly from one fund management group to another. 

A number of socially responsible actively managed funds still support fossil fuel companies and need to be aware of investors changing behaviours.

Future state

While the wide adoption of ESG analysis by asset managers over the last 10 years find its roots in enhancing risk management and performance, the recent increase in ‘sustainable’ fund launches is definitely more client driven.

According to the 2015 Nielsen Global Corporate Sustainability Report, 66 per cent of global consumers say they are willing to pay more for sustainable brands and 73 per cent of millennials are willing to do so. 

While there is a growing interest from investors of all ages, millennials in particular want their investments to reflect their social and environmental values.

According to a survey published by Morgan Stanley, 86 per cent of polled millennials are either very or somewhat interested in sustainable investing and 61 per cent of them have taken at least one sustainability oriented investment action in the last year. 

With $4tn (£2.9trn) expected to be transferred within a generation in theUK and North America alone according to Royal Bank of Canada, it’s no surprise that we have seen a number of banks setting up sustainable and impact departments.

Unfortunately, the financial crash and the volatility of the markets have led to a state of general distrust towards financial institutions, especially among the millennials.

The need for clarification

While far from being perfect, Mifid II has been successful in pushing for greater cost transparency but unfortunately nothing on sustainability. 

Reviewing key investor information documents, key information documents or factsheets usually tells you nothing about how sustainability is embedded within the process of a fund. There have been some initiatives like the Morning-star Sustainability Rating but the results have been widely criticised and I would argue confuse investors even more.

I’d like to see further clarity around the strategy each sustainable fund is pursuing, themes or sectors they are favouring and screening out, as well as the publication of the full list of holdings on a regular basis. 

Investors also want to understand the impact they are achieving so reporting on impact should become mandatory for all funds. Definitely something to suggest for Mifid III.

Damien Lardoux is a portfolio manager at EQ Investors