Warming to responsible investing

Whether it's the new Tesla cars that everyone is talking about, equality of remuneration for women, or collapses of finance companies during the GFC; Environmental, Social, and Governance (ESG) issues are a prevalent theme of discussion.

Monday, December 7th 2015, 12:33PM

by Harbour Asset Management

Similarly, in the asset management world, there has been an increasing proliferation of funds that purport to address these particular issues through various investment strategies, all housed under the labels of Social Responsibly Investing (SRI), Responsible Investing (RI), or ESG.

ESG investing for equity fund managers usually consists of one or a combination of the following strategies; negative or positive screening, integration, or engagement. In short:

Screening is the process of limiting your investment universe to stocks which fall into a certain category. For example, not investing in tobacco or alcohol companies is implementing a negative screen.
Integration is the process of acknowledging and incorporating ESG, or non-financial risk, into a fundamental analysis of a company. For example, placing a higher multiple on a company with exceptionally strong corporate governance.
Engagement refers to fund managers effecting positive behaviour for the shareholder in the underlying corporate by leveraging their ownership in that corporate. This could be through, for instance, dissuading management from a poor capital investment decision, such as further mine exploration (due to the risk of sunk assets), rather than returning capital.

The traditional view was that pursuing socially responsible goals would be detrimental to fund performance. Early global studies found evidence supporting all outcomes – some arguing that ESG has a negative effect on performance, some arguing the opposite, and some saying no measureable effect at all.

More recently, research has trended to documenting a positive performance effect from ESG. Compelling evidence is published in two metastudies (studies that summarise the findings of multiple research sources); Clar, Feiner, and Viehs, 2014 (University of Oxford), and Fulton, Kahn, and Sharples, 2012 (Deutsche Bank). Both papers reviewed data from over 200 studies worldwide and concluded that there are a myriad of benefits to a responsible investing strategy. These included a lower cost of capital, better operational performance, and a stronger share price performance. The New Zealand Super Fund has cited these as major validation for its belief that "responsible investing pays off."

There are many reasons why studies’ results are now more supportive of ESG factors as a contributor to performance. This article won’t touch on them all, however, it will provide a couple of simple explanations.

1. Earlier poor performance may have been due to the simple application of ESG investing strategies. For example, divesting from oil companies, while admirable, meant missing out on a strong resource rally over the past two decades. Best practice ESG investing now takes a more rounded integration approach.

2. We now have more experience and data to assess ESG outcomes. Fundamental to an ESG outlook is the long term perspective inherent in this view; global warming is unlikely to cause mass oil company bankruptcy tomorrow. Thus, earlier studies that found a negative effect on performance may not have had a large enough sample size; as the investment strategy has had time to play out, it may have reverted closer to its true mean.

Harbour's strategy for ESG is based on the following belief: Companies who manage ESG issues well are more likely to create long-term shareholder value, with a reduced risk profile and a lower cost of capital, compared with those companies who do not. Consequently, Harbour has integrated ESG factors directly into our company ranking process. ESG factors are assessed in conjunction with existing comprehensive financial analysis. Our primary ESG tool is our proprietary Corporate Governance Survey (CGS), which we augment with external ESG specialists and broker research .

As a general philosophy we have not restricted companies from our investment universe solely based on their ESG score; rather, we seek to constructively engage with companies to encourage ongoing improvement in CGS practices in the business community. For our Harbour Australia & New Zealand Equity Income service, we have identified several industries unfit for investment, including coal extraction, tobacco, gambling, and armament manufacturing.
While Harbour does not have a fund that is marketed as a defined "ESG" or "SRI" fund, our funds incorporate ESG considerations that we believe are best practice. Encouragingly, the United Nations-supported Principles for Responsible Investment (UNPRI) has awarded Harbour’s ESG approach an "A+", the highest mark possible,

Some investors have held long-term beliefs that there is more to measuring investment outcomes than just share price performance or dividend pay-outs. Investors today can have increasing comfort that fund managers are dedicating more attention to ESG considerations in a constructive approach that complements their end goal of delivering favourable performance for their investors.

- Blaine Abraham, Analyst at Harbour Asset Management

This column does not constitute advice to any person.

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