Embedding sustainability in an active investment strategy

15/04/2018

Environmental, social and governance (ESG) investing has entered the mainstream, and is transforming the way investors look at value. No longer are investments assessed purely in terms of financial returns; a host of other factors are considered, whether it’s a company’s carbon footprint or the impact a major infrastructure project will have on the local community. This is a welcome development, not least because these factors also have a demonstrable effect on investment performance. But ESG considerations add additional layers of complexity to the investment process that heighten the need for active portfolio management, backed by proprietary research.

The sustainability surge

were pursuing or actively considering

pursuing ESG integration

in their investment process within the last four years

Over the last few years ESG investing has seen extraordinary growth. A recent survey of institutional investors worldwide by the Morgan Stanley Institute for Sustainable Investing found 84% were pursuing or actively considering pursuing ESG integration in their investment process, and that 60% had started implementing ESG strategies within the last four years.

While Asia was a relative latecomer to the trend, ESG has also become a priority in the region, with major institutional investors like Japan’s Government Pension Investment Fund (GPIF) steadily taking steps to boost ESG allocations. Assets and products have emerged to meet this demand, from green bonds to funds targeting sustainable development.

Along with this shift have come efforts to define ESG factors and principles more clearly, and to identify and capture the added value these can bring to a portfolio. On the one hand, introducing more ESG-related requirements into a company’s processes can raise costs. Yet investments in areas like energy efficiency and employee health can also result in cost savings and productivity gains, benefiting the bottom line -- and ultimately investment performance. The growing body of academic research on the topic paints a fairly positive picture. Reviews of studies on the links between ESG and the performance of asset classes like equities, bonds and real estate have shown a clearly positive correlation.

ESG exporsure is

A SOLID

PREDICTOR OF RISK

ARCROSS THE GLOBAL EQUITY

INVESTMENT UNIVERSE

There is also a growing body of evidence that failing to consider ESG-related factors can expose companies and their investors to serious risks. The fallout from the 2013 Rana Plaza garment factory collapse in Bangladesh, which put global retailers under immense pressure to rejig their supply chains, or the massive losses suffered by Tokyo Electric Power Company Holdings (Tepco) on the back of the Fukushima nuclear disaster, are just two cases in point. Research indicates companies with solid ESG credentials tend to surprise markets less often than those with lower ESG scores, and that ESG exposure is a solid predictor of risk across the global equity investment universe. Thus it is important for the investors to consider this factor.

From active management to active stewardship

As a contributor to value and mitigator of risk, it’s increasingly clear ESG is a ‘good thing’ in investment as well as social or environmental terms. Yet investors should bear in mind that ESG considerations impact various asset classes in different ways. To give one example, the ESG frameworks applied to equities or corporate bonds may not be equally effective or necessary when it comes to infrastructure debt, since infrastructure projects are often subject to additional tiers of governance or covenants.

It’s also important to acknowledge that ESG factors need to be assessed and managed as rigorously as any other criteria in a portfolio strategy. For all the recent progress in sustainable investing several issues remain, including a lack of comprehensive or credible data across multiple environmental, social and governance metrics; inconsistent reporting standards among markets and industries; and inconsistent definitions of ESG from stakeholder to stakeholder.

Because data and standards around ESG can vary so widely, simply increasing allocations to any investment bearing the ‘ESG’ label can be counterproductive. It’s vital that ESG investment strategies have clearly defined objectives and are managed carefully. A truly integrated, active ESG approach must go beyond boosting ESG allocations and occasional portfolio adjustment, to encompass proprietary research that assesses and addresses ESG-related tail risks in portfolio holdings, and challenges established ESG scores that may or may not be an accurate gauge of an investment’s sustainability features.

Rather than simply accepting external metrics, this means independently developing a comprehensive methodology that measures environmental and social performance across a range of criteria, such as the greenhouse gas intensity of sales, workplace injuries or the gender mix on boards, to build an ironclad case for inclusion in (or exclusion from) a sustainability portfolio.

Active management in the ESG context should also include active stewardship; that is, regular engagement of the boards of companies invested in and contributions to companies’ ESG plans and goals. This level of involvement requires significant, dedicated and global ESG research resources, as well as a track record that establishes credibility and a strong network of contacts in industry and the sustainability sphere. These resources are the key to embedding ESG in an investment strategy that meets investor, as well as broader, aspirations for multiple forms of value.