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Tips for sustainable investing with your clients

By Justin Simler
January 18 2017
3 minute read
Tips for sustainable investing with your clients
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As environmental, social and governance issues take centre stage in 2017, let’s look at some key areas professionals should be across with sustainable investing.

In 2016, we stated that environmental, social and governance (ESG) investing was at an inflection point and would move centre stage for many investors.

Indeed, an October 2015 ruling by the US Labor Department, which permitted the managers of pension funds and 401(k) plans to evaluate ESG factors as part of their investment process, represented a key turning point for sustainable investing.

While investors have seen ESG criteria as increasingly important for reasons of best practice or they or their clients care about these issues, the evidence that incorporating an ESG perspective improves returns has been mixed.

Our own internal study using external ratings on companies didn’t find any evidence of improvement of returns from buying the best ESG companies, but at the same time we found that excluding the worst did not detract from performance.

However, we ask:

• Should investors be looking at whether including ESG criteria improves measures other than investment returns?

• Is there evidence that the risks attached to ESG factors are increasing?

• Is the nature of sustainable investing itself changing?

ESG factors: exclusive versus inclusive approaches

A recent study by Bernstein Research examined whether ESG factors – measured using metrics such as greenhouse gas intensity, training per employee and number of independent directors – improved performance, profitability or volatility using S&P 500 data from 2008-2015.

The study analysed the results excluding the ‘bad’ companies, focusing on the ‘best’ 20 per cent of companies and focusing on those companies that disclosed data.

It then compared these results to the broader market. The research revealed that one-year forward returns did not show a consistent improvement compared to the market.

But this isn’t the whole story, because on an individual factor basis:

• Environmental factors did improve profitability as measured by forward return on equity (ROE) and profitability as measured by forward return on invested capital (ROIC), while reducing risk (volatility).

• Social factors led to an improvement in risk.

• Governance factors exhibited perhaps the mildest affect with a slight improvement in risk.

• Overall, the inclusion-based approach scored more highly than the exclusion-based approach. This suggests that ESG may play a useful role in portfolio construction, especially given the potential for improving risk characteristics.

Are the risks from ESG factors increasing?

However, the 2008-2015 Bernstein Research might not be a good guide to the future. Change is ever present and all three elements of ESG are in a state of transition.

In July 2016, Singapore’s Changi Airport announced that it would build its new terminal 5.5 metres above sea level, which is higher than the level currently required to protect against flooding.

This indicates that construction may face higher costs in the short-term to be more sustainable for the longer term.

Meanwhile, social tensions are rising and the result of the UK referendum on membership of the EU can be seen as a protest against growing economic inequality.

When John Stumpf resigned as chairman and chief executive officer at Wells Fargo after the scandal concerning false accounts being set up by bank employees, the bank clawed back 25 per cent of his compensation from the previous 10 years.

Although the stock he took with him was still considerable, this set an unusual precedent for tougher governance, in contrast with how most bank chief executive officers were treated after the 2008 global financial crisis.

These anecdotes indicate what we mean by ESG itself is changing.

ESG and investing: a middle way?

Fund management companies have differentiated between how they view their own sustainability – the desire to actively reduce their environmental impact and ‘do better’ – and how they evaluate the companies in which they invest.

Although the role of ‘impact’ investing is growing, most managers are seeking to understand, and price in, ESG risks.

Where appropriate, they seek change by engaging with a company but would not exclude it as an investment.

However, in the future, fund management companies may well take a middle path.

In cases where ESG concerns are a significant issue, but the company in which they invest does not want to engage, they may decide to sell the holding regardless of the value that company offers.

This would require a more active interpretation of ESG criteria and would represent a subtle, but fundamental, change of approach.

Justin Simler, director, multi asset, Investec Asset Management