Responsible investing should be incorporated into an investors decision-making DNA because improving investment performance and driving profit makes financial sense, says Tracey Want, Head: Strategic Marketing, Investment Solutions.
Yet as soon as either ‘sustainable’ or ‘responsible’ are used to describe an investment approach most investors eyes glaze over at the thought of sacrificing gain for the benefit of some greater good.
This is because trustees of pension funds often think that the exclusion of companies with unfavourable environmental, social or governance (ESG) characteristics from a portfolio has the potential to “hinder returns by reducing the opportunity set available to an investor to generate high performance” says Tracey Want, Head: Strategic Marketing, Investment Solutions.
Most retirement funds target a return of CPI + 4% for active members with more than 7 years to retirement. The idea being that by growing a member’s assets within the fund by 4% above inflation a member should over time, with preservation and continued contribution, retire comfortably.
Investing responsibly is often seen as preventing trustees from earning the returns required to secure their members a comfortable retirement. Yet “the concept of exclusion popularised by high impact social development portfolios and Sharia’ah portfolio is not the only means to achieve responsible investing” says Want.
According to Investment Solutions, asset managers adopting responsible investing practices do so as part of their DNA which filters through to all their portfolios. “These are not niche or specialist managers focusing on small sectors of the market – they are some of the largest and best known asset managers in the industry” says Want. These managers typically consider the risks and opportunities evident in an investment by intentionally evaluating ESG factors as part of their investment analysis since these factors can materially affect the financial outcome from either a risk or return perspective.
Certainly, by adopting responsible investment behaviour and accepting the duties that come with share ownership, risk can be reduced – or at least better managed.
“At Investment Solutions we refer to this concept as earning responsible alpha, or achieving benchmark-beating returns while considering the risks and opportunities evident through the intentional analysis of ESG” says Want.
For example, running a company ethically according to good corporate governance structures means that a potential investor valuing the company can have greater confidence in the facts presented to them by management.
Certainly, companies that consider the community and environment before acting are less likely to be impacted by non-financial events that might materially impact a companies’ share price, like an oil spill or social dissatisfaction – ‘spontaneously’ manifesting in unrest and business interruption. By identifying these non-financial risks share owners are simply better informed to make quality decisions. Then, once the decision to buy has been made a responsible asset owner should accept the duties that go hand in hand with that ownership.
“Paying attention to ESG issues promotes better business practices allowing the asset owner more predictability in forecasting earning streams” says Want. This benefits the investor in the long run by placing them in a better position to achieve the inflation-beating returns required to secure comfortable retirements.
There are numerous studies that support the idea that companies operating in a high sustainability-conscious framework provide more attractive earning streams.
In the below study by Christopher Greenwald, U.S. companies with stronger ESG scores beat earnings estimates more frequently than those with lower scores. Using Asset 4 ESG scores the study showed that companies in the lowest quartile issued annual earnings announcements that exceeded estimates 61.5% of the time, while companies with ESG scores above 75% and 90% exceeded estimates 70.3% and 70.8% of the time.
A study by Eccles, Ioannou and Serafeim concluded that companies that have voluntarily embraced a sustainable business culture of many years significantly outperform their counterparts over the long-term, both in terms of stock market and accounting performance.
The study compares a portfolio of 90 High Sustainability organisations that adopted a substantial number of environmental and social policies since the early to mid-1990s with a similar number of Low Sustainability companies that adopted almost none of those policies. The financial performance of the two groups was tracked for an 18-year period ending in 2010. The report highlights that an investment of $1 at the beginning of 1993 in a value-weighted portfolio of High Sustainability firms would have grown to $22.6 by the end of 2012, based on market prices. A similar investment in a value-weighted portfolio of Low Sustainability firms would have grown to only $15.4 by 2010.
The findings of the study imply that companies can adopt environmentally and socially responsible policies without sacrificing shareholder wealth. In fact, the opposite, namely, adopting environmentally and socially responsible policies, appears to be more likely to deliver greater value.
Investment Solutions is of the view that while evidence still exists for and against including ESG factors into the investment decision making process, a lot can be said for the common sense benefits gained, namely; “a reduction in risk and more inclusive decision making – coupled with smart active ownership” says Want.
The big take-away for now is for investors to remember that sustainability is not a swear word. Nor is it a product or portfolio. Instead, it is “a common sense investment process that focuses on new opportunities and risks that arise through the conscious evaluation and monitoring of ESG factors” says Want.
Certainly, with sufficient evidence supporting positive financial outcomes at lower levels of risk there is every reason to be questioning asset managers about how they use and manage these issues on behalf of the trustees and members of pension funds.