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Environmental, social and governance (ESG) investing is a hot topic but new research has highlighted widespread confusion over exactly what it means, how it informs investment decisions and its potential impact on returns.
ESG and, more broadly, sustainability are high priorities within Lloyds Banking Group. The company is a signatory to the United Nations Principles of Responsible Investment, we recently incorporated ESG factors into our smart beta funds and we offer over 80 sustainable investment choices through our fund super market.
However, ESG terminology and investment choices can be confusing and we need to get back to basics to make it easier to understand.
It’s not just less sophisticated investors who struggle with ESG issues. For example, the UBS Investor Watch Report1 found that 79% of high net worth individuals are confused over terminology. Investors look to financial advisers for guidance, with 90% saying advisers influence their ESG investment decisions, but financial advisers also want more information from investment institutions.
It is little wonder there is confusion, as the terms such as responsible and sustainable are often used interchangeably, while some use ESG as a catch-all term. The Schroders Global Investor Study 20172 refers to ‘sustainable’ investment as the number one topic on which investors want to improve knowledge.
HSBC3 conducted a survey of 200 UK advisers which found that 34% believe limited understanding of ESG issues affects client demand for ESG-related investment strategies or products, while 58% of financial advisers want more ratings for ESG products.
Nevertheless, investors increasingly recognise that achieving good returns and having a positive impact on society and the environment are not mutually exclusive aims. Several studies show that companies that are ESG leaders tend to achieve better business and stock market performances than ESG laggards.
The UBS Investor Watch report1 found that 82% of investors believe the returns of sustainable investments will match or surpass those of traditional investments. The rationale is simple; they view sustainable companies as responsible, well-managed and forward-thinking, making them good investment prospects.
So far, so good. But how do we plug the wider ESG knowledge gap? Clear definitions would help. MSCI4 defines ESG investing as ‘the consideration of environmental, social and governance factors alongside financial factors in the investment decision-making process’.
The purpose of integrating ESG issues into the investment process is to help identify investment risks and opportunities that can impact long-term returns and provide an opportunity to quantify and mitigate risk and capitalise on growth opportunities. We adopt this approach when assessing both equity and fixed interest assets.
1. Environmental: spanning climate change, resource depletion (including water, timber and carbon energy sources), waste and pollution.
2. Social: labour relations, worker rights and working conditions, slavery, child labour, health and safety, community impact, workforce diversity.
3. Governance: executive pay, bribery and corruption, fraud, financial reporting, risk management, political lobbying and donations, board diversity, director tenure, board skill sets, tax policies.
There are different ways to incorporate ESG into investment processes.
i) Stewardship – engaging with companies as a shareholder and using voting rights and direct negotiation to effect change.
ii) Integration of ESG factors into the investment decision-making process.
iii) Themed investing e.g. sustainable investment in clean tech or waste management.
iv) Impact investing with the aim of achieving a specific measurable positive impact on the environment or society.
v) Exclusionary screening for activities not aligned with investors’ values – e.g. weapons manufacture animal testing, pollution.
Sometimes ESG is associated with active rather than passive funds, however, customers whose pension assets are in passive default funds also benefit from stewardship on ESG issues. Stewardship is a powerful way to hold corporates to account and protect long-term investments.
As shareholders we can influence companies’ behaviour through stewardship in several ways. We can do it through membership of the Institutional Investors Group on Climate Change (the IIGCC represents more than €21 trillion in assets5); and through external fund partners, including State Street Global Advisers (SSGA), who undertake stewardship on our behalf.
SSGA demonstrates the positive impact of stewardship in its latest report6. SSGA mounted a campaign on gender diversity on boards, dubbing it ‘Fearless Girl’ after the statue of a girl facing down the ‘Charging Bull’ on Wall Street, which it created to publicise the campaign. SSGA says companies with strong female leadership perform better, achieving an 36.4% average increase in return on equity. Its engagement resulted in 152 companies adding a woman director and 34 more planning to do so. It also voted against more than 500 companies that failed to respond to requests to add a female director.
ESG investing is increasing in response to growing investor demand. According to the Global Sustainable Investment Alliance 2016 report7, sustainable investment has grown in both absolute and relative terms, with $22.89 billion of assets worldwide now professionally managed under responsible investment strategies.
This reflects hard-headed decisions. HSBC3 says investors are clear on potential financial benefits, with 74% saying financial returns are key to their ESG decisions. Meanwhile Schroders Global Investor Study 20172 reported that 78% of investors regard ESG or sustainable investing as more important to them now than five years ago.
Hermes Fund Managers posed a critical question in its 2014 study8: ‘ESG investing – does it make you feel good or is it actually good for your portfolio?’ It scrutinised returns from 2009 to 2013 and concluded that companies with high ESG scores tended to outperform companies with low scores by an average of more than 30 basis points per month.
Other studies have found that companies with robust ESG practices are likely to have a lower cost of capital, less volatility, fewer instances of bribery and corruption, and are less likely to be exposed to systemic risk or specific sector risks. They argue that the reverse is true for companies with poor ESG practices.
MSCI4, which analysed how ESG affects equity valuation, risk and performance, cites the example of Volkswagen which has been engulfed by a scandal concerning emissions tests on diesel cars in the United States. As a consequence of governance failures, Volkswagen is under fire on several fronts, its deposed CEO faces criminal charges and investors are suing for damages.
The ‘G’ in ESG is assuming greater importance as companies grapple with multiple challenges including: climate change, natural resource shortages, pollution, cyber security, and corruption and diversity concerns.
Consequently, even sceptics who previously regarded ESG as a niche or fuzzy issue are paying attention to the growing body of research containing hard data on the impact ESG can have on returns.
As more Millennials become long-term investors, experts forecast even greater interest in ESG investing to make a positive impact as well as making money. That is another important reason to improve understanding of ESG, not just for existing customers but for investors of tomorrow.
1 UBS Investor Watch report, https://www.ubs.com/uk/en/wealth-management/our-approach/investor-watch/2018/return-on-values.html
2 Schroders Global Investor Study 2017, https://www.schroders.com/en/sysglobalassets/digital/insights/2017/pdf/global-investor-study-2017/theme2/schroders_report-2__eng_master.pdf
3 HSBC, https://www.moneymarketing.co.uk/521043-2/
4 MSCI, https://www.msci.com/esg-investing
5 IIGCC, http://www.iigcc.org/about-us/our-members
6 SSGA Annual Stewardship Report 2017, https://www.ssga.com/home.html
7 Global Sustainable Investment Alliance report 2016, http://www.gsi-alliance.org/wp-content/uploads/2017/03/GSIR_Review2016.F.pdf
8 Hermes Fund Managers report 2014, https://www.hermes-investment.com/wp-content/uploads/2015/06/esg-investing-does-it-just-make-you-feel-good-or-is-it-actually-good-for-your-portfolio.pdf
Investment markets and conditions can change rapidly and, as such, the views expressed in this update should not be taken as statements of fact nor be relied on when making investment decisions. Forecast are opinions only, cannot be guaranteed and should not be relied on when making investment decisions.