Investing responsibly: passing the tipping point
Do you believe that well governed companies have better long-term prospects than their competition? If you do, then you have already taken the first small step to aligning yourself with a more sophisticated approach to responsible investing (RI).
Tuesday, August 8th 2017, 9:11AM 
2 Comments
by Pathfinder Asset Management
NZ’s staggering RI growth
The Responsible Investment Association of Australia recently released its Responsible Investment Benchmarking report for the 2016 year. For those interested in responsible investing, it showed some quite remarkable growth in funds in New Zealand managed using responsible investing guidelines. With year-on-year growth of over 2500% (from NZ$1.6 billion to NZ$42.7 billion), at face value the report indicates quite a remarkable transformation in the NZ managed funds scene.
Yet the picture isn’t quite as dramatic as it first appears. In August of last year, the New Zealand Herald published a story pointing out many Kiwisaver funds owned shares in companies that are banned by various United Nations Conventions (land mines, cluster munitions, nuclear weapons). In response to this story, most affected Kiwisaver funds took an initial step into the Responsible Investing world by implementing an exclusions based policy, removing where possible the few companies affected by the UN conventions.
Some providers moved much faster than others – in fact some are only implementing changes now. This illustrates for some how difficult it will be going forward to have a dynamic RI policy when they outsource the stock selection.
But are exclusions enough?
Globally, responsible investing has moved far along from a purely exclusions-based policy. In fact, many argue that managers following an exclusions policy only are merely paying lip service to the ideals of responsible investment. It is a reactionary approach and indicates a lack of belief in the idea that well governed, socially and environmentally responsible companies will tend to be better than their less enlightened peers. It also indicates a negative world view by exclusions only investors – are they excluding companies because it is a well thought-out policy or just because regulators and clients are forcing them?
In broad terms there are four approaches to responsible investing: Negative screening or exclusions, thematic investing, impact investing and full Environmental, Social and Governance (ESG) integration. As well as these, there is the concept of engagement – voting at AGMs and applying positive pressure for companies to improve their ESG policies. Different managers can use some or all of these in different ways. At Pathfinder, we certainly start with this exclusionary approach, but go further to fully integrate ESG factors.
Exclusion-based investing, though a start, is actually a negative way of looking at responsible investments. Managers take out companies from certain industries – i.e., Tobacco, Controversial Weapons, Gambling, Adult Entertainment and Thermal Coal production/usage (sorry President Trump!). In terms of responsible investing, exclusions is taking a step, but the bare minimum step.
As its name implies, thematic investing is an approach where the investments chosen in a portfolio are consistent with a particular narrative. Examples include low carbon emissions, social justice, solar energy and, in the case of Pathfinder, our Global Water Fund that invests only in companies that have significant revenue from activities that support the treatment and distribution of fresh and waste water.
Impact investing is harder for managers investing in listed companies as these are normally private (unlisted) investments. The idea is that capital owners will invest where their investment can generate measurable and beneficial social or environmental impact. This may or may not be at a monetary cost. Well-known impact investing include micro-finance initiatives in less developed countries, investment in infrastructure to provide safe water and community-based health projects. The capital owners may be content with a lower financial return if they value social benefits more highly.
Full ESG integration is where the responsible investment industry overseas is fast migrating to. It is much less a leap of faith now than it was several years ago. Previously, when asked, most investors would state that ESG investing implies a lower return than non- ESG investing. Now, that conversation is changing, as investors now agree that funds following an integrated ESG approach will do no worse than average, and may in fact do better. Data from the RIAA shows returns for three sectors (Australian share funds, International share funds and Multi-sector growth funds) across timeframes of up to 10 years. RI is behind over one year but over three, five and ten years, RI funds did the same or better over seven out of nine periods.
How is ESG incorporated?
ESG integration is here and will only become more important as investors demand it, and track records are generated. In practical terms though, how do managers implement it? Some just do their normal stock analysis and then check each stock for “appropriate” levels of ESG-ness before buying it. A safe approach but, again, these managers aren’t fully invested in the benefits of ESG as an investible factor.
At Pathfinder we take a much more direct route. We believe (and there is ample evidence) that the ESG characteristics of a stock have a direct impact on the relative return for that stock. More simply, in the long run, we believe that stocks with high ESG scores will outperform peers who do not have high ESG scores. Logically this makes sense – high governance scores should imply that a company makes better, more robust decisions. High environmental scores mean fewer incidents that could result in legal actions or clean up costs. And high social scores should mean better engagement with customers, a happier and more productive workforce. None of that is difficult to appreciate. In our responsibly invested equity funds we actually treat ESG scores as a market factor, in the same way as we look at geography, sector, value factor, growth factor, dividend yield factor etc. When we build a diversified portfolio from our exclusions-screened universe, we value more highly companies with high ESG scores than their peers and, essentially maximise the overall portfolio ESG score, subject to constraints and minimums/maximums around other market factors.
Increasingly, the investors we speak to are demanding a more integrated approach to ESG, and seeking out portfolios that match their own core beliefs, but comfortable in the knowledge there is not necessarily a performance gap for being responsible.
Paul Brownsey
Pathfinder is manager of its Global Water Fund and Responsible Investment Fund.This commentary is not personalised investment advice - seek investment advice from an Authorised Financial Adviser before making investment decisions.
Pathfinder is an independent boutique fund manager based in Auckland. We value transparency, social responsibility and aligning interests with our investors. We are also advocates of reducing the complexity of investment products for NZ investors. www.pfam.co.nz
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Comments from our readers
I would argue that the data is quite supportive of the statements I have made. For instance, a recent BoAML study (Dec 2016) found a few very interesting conclusions.
1. The top third of ESG scored companies outperformed the bottom third by over 18% over the previous 10 years.
2. ESG scores are highly correlated to future risk. Low score companies had much higher future draw downs than high score companies.
3. If an investor only bought companies in the top 50% of the ESG scores you would have avoided 90% of the bankruptcies that occurred in the following 5 years.
Also good predictive ability around future earnings volatility and ROE.
There is plenty of other research, both academic and industry to support the case for ESG integration on purely value terms.
You may be right that in a perfect market world these effects would be arbitraged away but it seems like we are not there yet. Perhaps we are still at a point where numerous investors - and perhaps this is the weight of passive money which is an increasing share of liquidity - dont care about ESG integration and buy good and bad companies indiscriminately. In a perfect market you would also assume that equity factors like value, size, earnings growth etc would also disappear, yet they persist. Combine large weight of purely passive money with the well documented cognitive biases exhibited by many investors and perhaps there is your answer.
Congrats on your 59.9% return but I would politely point out that the plural of anecdote is not data. Obviously poorly governed companies can go either way, kudos if you can select only the winners and never the losers, but a high idiosyncratic risk seeking approach is a perfectly defensible strategy if the investor understands the risks but I regard it as akin to snatching nickels from in front of a steamroller. One or two failures in a portfolio of low G companies would wipe out gains from your winners.
Another point is that there are many degrees of what people care about with respect to ESG investments. Not all ESG funds exclude weapons for instances - on the weapons front we exclude those companies that are not consistent with NZ's UN obligations, but not every company in the defense sector.
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Your first question is an interesting one. Personally I don’t believe it and I think that people who think that are taking a simplistic approach. It ignores the fact that other people might also perceive poorly governed companies as being poorly governed and price them accordingly. Some of my very best investments and I am talking 59.9% pa compound for five years (a great example) have been poorly governed companies. The reason that they outperformed is because sooner or later the directors got the boot and they became well governed. I’m buying one stock presently at a valuation 1/3 below its peers because it is perceived to be badly governed. With a well governed company you don’t have that opportunity. The obvious risk is that you can’t pick when a poorly governed company is going to become, if ever, well governed.
My point is that simply saying well governed companies have better long term prospects is simplistic unless the fact that they are well governed is not obvious to all and sundry. In an efficient market that is a pretty silly thing to believe but I guess you have to say it if you have a product to sell.
Whilst investing responsibly is possibly a good thing that isn’t clear to me. For example if every western country stopped investing in weapons we might have a change of government without a vote before too long. I tell my clients invest widely and if you feel like helping your fellow man/the environment/whatever give some of your money away to charitable causes. When I then tell them those sorts of funds have much higher fees than more diversified funds normally that is what they do.
Regards
Brent Sheather