Victoria Hasler, Director, Research & Consulting at Square Mile discusses how investment managers today are integrating environmental, social and governance considerations.
AN OVERVIEW OF THE MARKET
The Business Roundtable, a prestigious association of American chief executives, shook up the business world recently, when it redefined the purpose of a company. For as long as anyone can remember, the primary focus of public companies has been to increase shareholder value. This group has put out a statement, however, signed by almost 200 CEOs, saying that companies should also look out for the interests of customers, workers, suppliers and communities, and aim to increase diversity and protect the environment. It seems the world is changing, and that includes investment.
There is no doubt that ESG (Environmental, Social and Governance) is a term increasingly heard in investment circles, from asset managers, investors and the media. Spurred in part, no doubt, by the increasing focus in wider society on issues such as plastic pollution and climate change, which have received some high-profile media attention in the last few years, conscious consumerism is a growing trend, and investment is no exception.
While the absolute amount of assets invested in strategies that employ ESG remains relatively small, flows into these funds are picking up steadily, and growth in these assets is surprisingly fast, albeit from a low base. The fund management industry has picked up on this, of course, and we have seen a number of fund launches using ESG approaches of various kinds. One figure suggests that the number of responsible funds which employ ESG available in the UK has increased tenfold in the last 20 years.
Concentrating on the growth of the number of funds in the industry can be a bit misleading, however, because the other trend which is fast gripping the industry is that of ESG integration. Simply put, this assumes that rather than investing in specific responsible funds, investors expect all their funds to look at elements of environmental, social and governance factors as part of their normal research and investment processes. Managers who support this trend would argue that looking at these factors makes sense not just from the point of view of delivering better ESG outcomes for investors, but from a financial point of view as well. The logic is that companies which think about these factors should be better placed to thrive in the future. While the logic is irrefutable, the evidence is less so, and because of the reasonably long time horizons involved in investing, it may be some years before this can be conclusively proved one way or another.
Those who have been investing ethically for many years will have noticed another relatively recent trend. Historically, many funds which have labelled themselves as “ethical” have applied negative screens to their investment universe. They may well have used the exact same investment process as their peers managing conventional funds, but applied a screen to exclude companies whose revenues derived from, for example, tobacco, oil and gas, armaments, alcohol etc.
The more recent launches in the responsible space, however, have leaned towards a positive engagement approach. Different managers will interpret this slightly differently, but the basic premise is that, rather than excluding companies involved in “dirty” industries or practices, it is better to engage with them to encourage and reward good behaviour, and to try to change these industries from within. An example might be investing in an energy company which derives a large percentage of its profits from oil and gas, but is investing heavily in clean energy solutions such as wind and solar. In this way, advocates argue, investors can be a force for positive change in the world.
CHALLENGES FACING THE INDUSTRY
There are several challenges facing the industry at present, but one of the biggest is simply confusion. Confusion around terms, confusion around the best approach, confusion as to who is using real ESG approaches and who is green washing. There is even confusion over whether ESG is a real trend or simply a fad. In this environment one can hardly blame investors for being slightly bamboozled.
Let’s start with the fundamental questions. What is ESG? How far should it go? What should it include? Are negative screens better or worse than positive engagement? Or do you need both? The problem is that ESG means something different to each investor. To one person it’s carbon footprint that is overriding, whilst for others the thought of investing in pornography and tobacco is repugnant, and negative screens are therefore a must. Other investors are happy to invest in “bad” companies if their fund managers are actively engaging with the companies to try to improve them. As with any investment it is important, as an investor, to know what you want from a responsible fund. This is the starting point to go and find one that meets your objectives.
Confusion around language and terminology is also rife. The terms ethical, ESG, sustainable and impact, to name just a few, are used almost interchangeably by many investors. Even more confusingly, when asset managers or investors do define what they mean by the terms, each one defines them slightly differently. We desperately need some standardisation in terms and in the way in which we talk about this topic. Thankfully, the IA is doing some great work here and its framework for responsible investing is likely to address at least some of the confusion. We think this is a great initiative and would welcome any clarity in this area.
Another challenge, one which is whispered about, but of which investors should be aware, is that of green washing. Let’s start by saying that there are some truly outstanding responsible funds out there, as well as some asset management groups who are very serious about integrating ESG across their businesses. Many of these groups and funds are doing amazing job of delivering ethical, impact and sustainable outcomes for investors. Unfortunately, whenever there is a trend for something you are bound to find some people jumping on the bandwagon who have no right to be there. All we will say on this is that, as with any investment, it is important to do your research and to make sure that what you are investing in is meeting your desired outcomes, be they monetary or otherwise.
THE FUTURE OF THE MARKET
As the market for responsible funds grows and matures, there are several ways it could develop. We expect, more and more, that asset management groups will want to integrate ESG into their investment processes on all funds, to a greater or lesser extent. This is likely to become a hygiene factor which investors will simply expect.
At present the market seems to be moving more and more in the direction of positive engagement, rather than funds which simply apply a negative screening process (exclusion funds). If this trend continues then it will present another challenge for the market – that of measuring success. It is relatively easy to measure success in financial terms (performance), but a large part of the philosophy investing with a responsible mindset is to recognise that not all costs and benefits of investing are monetary. So how should investors measure the non-monetary benefits (and costs) of investing? This is, as yet, a rather undeveloped art (and it probably is more art than science), and it will be very interesting to see how it develops. A potential solution is to try to map investments to the UN Sustainable Development Goals (SDGs), although this is diffcult to do and anyway probably not a perfect solution. One thing is for sure though – as the market develops, investors will start to demand better reporting on the sustainable/ impact/ exclusion side of investing, and it will be interesting to see what solutions the industry can design.
CONCLUSION
Whether or not you want to invest on an ethical or sustainable basis, there is no doubt that the trend for ESG investing is growing. As investors become better informed, and managers become better placed to offer solutions, it will be exciting to see how this space grows. Perhaps it is time for the industry to stop skulking in the slightly dark finance corner and get out and make a positive impact on the world.
In October, Square Mile launched ESG integration across their Academy of Funds and have also launched Responsible ratings. Find out more at squaremileresearch.com
Victoria Hasler, Director, Research & Consulting at Square Mile
Article taken from Hub News Issue 43.
