Future-proof investments

Corporations that transgress environmental, social and governance (ESG) standards are increasingly recognised as an investment risk by asset managers. Concern over governance isn’t new of course, the Enron and Andersen Consulting auditing scandal is the most famous example of failed oversight that had dire consequences. Social issues are a more recent priority, but given many of the world’s biggest companies’ business models depend on sensitive consumer data, considerations such as privacy take on financial implications for shareholders. When it comes to the environment; the public, governments and regulators are no longer just concerned with one-off events such as Deepwater Horizon and Exxon Valdez. The widespread fear of catastrophic man-made climate change and plastic-filled oceans increases the likelihood polluters will face operational restrictions and be forced to pick up the tab for externalities relating to continuous activities.

ESG: a question of risk and reward

Limiting exposure to companies that face structural operational challenges is just common sense and due diligence on corporate governance is investing 101. Indices created by MSCI weighted on ESG factors have outperformed the rest of the market since 2010, largely because they have been comparatively less exposed than the benchmark to shares that have fallen on the back of scandals. Anecdotally, the index rules suggest a correlation between companies that behave well day-to-day and those that avoid the worst corporate blow-ups. Think of former mayor Rudolph Giuliani’s zero tolerance of minor infractions on the New York subway and a fall in serious crime. With shares, sustainability first policies could mean side-stepping businesses on the verge of ignominious falls and not getting overly sucked into bubbles such as technology in the late 1990s or banks in the mid-2000s (and maybe UK property now).  

Metrics used to screen for companies that have lower sustainability risk are based on the three pillars of ESG, sub-divided into themes and key issues. The MSCI indices split environment into themes pertaining to climate change, natural resource management, pollution and waste, and positive screens for renewable energy and clean technology. Broad social themes are labour rights, product safety records, materials sourcing and positive screens on employee benefits. Corporate governance is split into traditional due diligence overviews (of stock ownership, board make-up, accounting audit and executive pay) and tests of corporate behaviour, for example tax transparency and fair competition practices.

The distinction needs to be made, however, between ESG and traditional forms of socially responsible investing (SRI). There are two forms of SRI, the first is 'light green', which generally means positively screening for companies that have made progress on issues such as green energy, diversity in the boardroom and community projects. The second, 'dark green' category involves negative screening, where any company involved in fossil fuels, plastic packaging, tobacco, alcohol or armaments might be excluded.

More stringent dark green SRI screens are often bespoke for investors with moral concerns. While it is easy to exclude one type of business, such as tobacco, having a set of objections across industries can greatly reduce the investment opportunity set. Strict funds have developed a reputation for being risky, as securities held can be smaller and less liquid. In the case of positive green investments – for example innovators in renewable energy – the companies that issue bonds and shares can be dependent on government subsidies, lack diverse revenue streams, or use technologies that are easily disrupted by the next big thing.  

The broader ESG approach to investing is to tilt the composition of benchmark indices away from market capitalisation. Representation of companies in the benchmark is altered by ESG scorecards, which means the index is overweight those companies with better ESG ratings and underweight those that don’t score so well. There are differences between providers’ methodologies but, broadly speaking, companies are assessed most rigorously in areas where they have a high impact (for example carbon emissions for oil and gas companies) and their overall ESG score is used as a tilting factor to the market capitalisation, to give a new weight in the index.

At the most basic level, ESG means underweighting, rather than excluding, companies based on their scores, which as MSCI has found can lead to outperformance. Its tilted ESG indices have done better than market capitalisation-weighted products, covering all regions, over the past nine years. This is thanks to being underweight companies such as Volkswagen (VW) when it was found to be juicing emissions data reports, Facebook (US:FB) in the wake of the Cambridge Analytica data scandal, and Danskebank as it was subject to one of Europe’s biggest money-laundering investigations.

Recognising that ESG requirements vary by client, providers such as MSCI and FTSE offer a suite of indices. The FTSE4Good series started in 2001, but this broadly tilted index approach might not be enough for some clients who want to be sure they aren’t invested in certain activities. Some of the other ESG indices FTSE maintain include the FTSE All World excluding Fossil Fuels index and the FTSE All World excluding Controversial Weapons index (which also has a tilt to limit climate impact). Both have performed well against the parent FTSE All World, as the chart below shows. yet while index companies are to be applauded for their innovation, more needs to be done to be clear to investors about what these products do and don’t include.  

Since the 2007-09 bear market, stock markets haven’t faced panic followed by a period of sustained selling pressure. There have been crises, such as the Greek sovereign debt bail-out, but the combination of strong US growth and powerful monetary stimulus globally has helped prevent such episodes becoming market routs. Against this backdrop of upside support, market indices have done well, so being less exposed to the companies that experienced idiosyncratic difficulties has helped eke out some additional returns.

The true test will be a market-wide sell-off, although there may also be reasons for optimism that ESG-tilted indices will hold up well. For example, the US market has been driven in no small part by the expanding valuation multiples of the FAANG stocks – Facebook, Apple (US:AAPL), Amazon (US:AMZN), Netflix (US:NFLX) and Alphabet (US:GOOGL). Thanks to their weak scores on social screening criteria around data privacy, and in some cases dubious records on failing to act on harmful content being distributed, these companies are less prominent in ESG than market capitalisation-weighted indices. The most expensive companies have furthest to fall, so there is also an argument that with their lower exposure ESG indices could suffer less in a bear market.

Is the ethical label being misappropriated?

Bear markets are a rite of passage for any long-term investing strategy but, withstanding the enormous caveat that most indices are in their infancy, risk management is the starting point for ESG. Being part of a capital allocation process that is more beneficial to society and the environment is a welcome aspect of the approach, but the soft form of ESG doesn’t guarantee investors avoid companies engaged in harmful activities.

There are further levels of ESG screening that have more exclusions, and both MSCI and FTSE provide stricter options. These indices have, against the backdrop of ultra-liquid markets since 2010, also outperformed and in some cases given investors zero exposure to companies embroiled in controversies of the day. Yet, as the monetary policy taps are tightened, trade-offs between liquidity and moral concerns will become necessary. This may impact the type of ethical solutions that can be offered to clients. Liquidity is crucial to the sorts of products that enable millennial investors to purchase small amounts of stock in exchange traded funds (ETFs) that comprise the green and responsible investing options marketed to them. The worry is products with a very mild ESG tilt could be presented to investors in a manner that wrongly suggests they are ethical funds.

Incorporating ESG in stockpicking and portfolio management

Institutional pioneers in the ESG space provide a useful template for private investors. Large insurance firms such as Aviva (AV.) and Legal & General (LGEN) were right at the top of the ShareAction charity’s 2017 survey on asset managers’ ESG performance. Both groups have demonstrated high levels of engagement with companies to ensure good outcomes are reached for stakeholders, including their end investors and society at large.

Willingness to use the voting powers vested in them, and as a last resort divest funds from companies that are unresponsive to flagged ESG issues, has not only helped these asset managers act as luminaries for stewardship, but it has also provided a continuous learning curve for evolving investment strategies that manage ESG risk. For example, Legal & General has been feeding responsiveness of companies to votes at their annual general meetings (AGMs) into their index scores for passively managed funds. This is an innovative way of looping active stewardship back into passively managed investment products. It also means the methodology behind the indices themselves is constantly evolving to reflect the needs and concerns of end investors.

Examples of the approach to individual companies are a lesson in the questions investors need to ask when assessing a good long-term investment. The Global Responsible Investment team (GRI) at Aviva employs an ESG heat-map, which includes an internal governance rating based on its own voting records. This is supplemented by fund manager briefings ahead of votes. Information services company Experian (EXPN) is a case study where an issue – data security – has been highlighted.

Credit services (55 per cent of Experian’s revenues at the time Aviva published its responsible investment report for 2017) and consumer services (22 per cent of revenues), leave Experian vulnerable to the risk of data breaches. Following the 2015 theft of 15m customers’ information from customer T-Mobile, Aviva keenly monitors this business risk. Operational questions such as how Experian has materially changed its approach to data management following the T-Mobile debacle – including what scenario testing and impact assessment processes are in place – are part of the scorecard approach.

Very large companies that Aviva engages with as an institutional investor include ExxonMobil and Royal Dutch Shell. These are companies the staunch environmentalist would probably choose to avoid, but for the pragmatic investor, who wants to enjoy the sizeable income offered but also keep an eye on sustainability, the progress made in response to institutional investors’ efforts at stewardship are a good indicator. It is very difficult even for an investor the size of Aviva to influence a US megacap such as ExxonMobil, but by 2017 they finally issued public support for the Paris Climate Accord and, in an important breakthrough, 62 per cent of shareholders (including Aviva) supported a motion for ExxonMobil to publish long-term portfolio impacts of global climate agreements. In February 2018, the first such report was produced, complete with two-degree climate change impact assessments.

Royal Dutch Shell has been more pro-active than its US peer in taking steps to start transitioning to a greener future. By leading on issues related to gas flaring, drilling in ecologically sensitive regions, portfolio stress testing and carbon reporting, Shell de-risks its position with regards to potential fines or public pressure in the future. The company was, however, identified as having more to do around linking long-term climate strategy with executive compensation. That said, the company’s stated commitment to halving the net carbon footprint of its products is a reassuring sign of a longer-term focus that acknowledges the ESG risk the company and the industry faces.

Legal & General Investment Management (LGIM) was ranked second out of the world’s largest 50 asset managers for its efforts on climate change in 2017, voting in favour of 95 per cent of climate resolutions at AGMs. Examples of its stewardship in other areas also throws up issues private investors should be wary of when assessing individual companies or deciding whether to get involved in IPOs. When Snap (US:SNAP) was listed in the US, with no voting rights for ordinary shareholders, LGIM engaged with index providers FTSE and MSCI to highlight the risk to clients were the stock admitted to standard indices and benchmarks. Following public consultations with the main index providers (also including S&P), Snap wasn’t included in major investable indices, meaning that LGIM was not forced to invest in a company with governance concerns (relating to shareholder rights) through its passive index holdings. Aside from the questions around how Snap can monetise its audience, no voting rights is a red flag for investors, so this is an example of where ESG concerns are a signal to avoid certain stocks.

Other governance issues that LGIM has used its scale to raise include remuneration policy at French auto giant Renault (Fr:RNO) and the conflict of interests in PricewaterhouseCoopers being auditor of Vodafone (VOD) and administrator of Phones4U. The Vodafone situation is not the sort of problem that investors might think to look out for but, given there was a possibility PwC might have to bring legal cases against Vodafone on behalf of Phones4U, there was a material threat. Of course, it’s a very different example from Enron (which was serious fraud) but considering ESG issues in respect of companies’ auditors, as well as their operations, is a valuable lesson not to be forgotten nearly 20 years on.

Action on asset managers

Charity ShareAction has spent the past 12 years building the movement for responsible investment; its mission is to “transform the investment system and unlock its potential to be a force for good”. Part of its work is reporting on the positive impact of asset managers that use their size and voting rights to affect change. Their 2017 Responsible Investing Ranking Survey gave high positions to Aviva and LGIM, and ShareAction is effusive in its praise of these organisations.

The voice of independent bodies that aren’t motivated by profit is important in giving credit where it is due in the asset management industry and taking collaborative steps to achieve better outcomes for society, the environment and investors. It is also important in flagging where the world’s largest asset managers could do more.

Governments, regulators and other international bodies are also increasing scrutiny of the asset management industry. The United Nations-backed Principles for Responsible Investment (PRI) is another strong voice for change, aiming to steer the efforts of the national departments that propose legislation, the chambers that pass them and the regulators that provide guidance and enforce rules. There is also a focus on major stock exchanges to provide better guidance to members and investors. The PRI has produced a set of guiding principles that it is working to get asset managers, institutional asset owners and exchanges to adopt, to move ESG to the forefront of how securities markets operate. The international movement is now being reflected in commitments signed up to by regional asset managers such as the UK Stewardship Code that’s put together by the Financial Reporting Council (FRC). The code is currently being revised, with ESG integral.

Crucially, this momentum is now translating into obligations for institutional investors that will have a knock-on effect for all market participants. Pension trustees who have a fiduciary duty to their beneficiaries will soon be required to make a statement on how they include ESG in mandates granted to asset managers. From October 2020, they must report on some of the outcomes. Gradual progress in making ESG integral all along the investment chain, from beneficiaries/asset owners to asset managers and via exchanges to companies that issue securities, will have an impact on share prices. The objective is to recognise the externalities of business, so capital allocation isn’t just skewed towards companies whose profit margins may be fattened by what amounts to a subsidy of their activities by society.

Source: MSCI 

ESG gathering pace across asset classes and regions

The process of ESG screening is equally applicable to debt markets and managers of fixed-income allocations are keen to demonstrate their incorporation of the principles in security selection. Sustainability fits well with the due diligence required in assessing credit and liquidity risk, although as with equities there is a distinction between ESG as risk management and strict principles-led investing.

Trade-offs between risk, return and morality are perennial, and difficult choices lie ahead as investors cast their net across more of the globe. China’s importance as part of the investment universe is growing to mirror its economic status, with notably more of its mainland-listed A-shares (on Shanghai and Shenzhen exchanges) being included in global indices. Yet, while there may be good reason to question some of the governance standards of Chinese companies (that have a reputation for being opaque), and there are undoubtedly concerns around labour rights, the country has shown a great willingness to engage on other issues, such as the environment. Furthermore, there is momentum towards a more rounded ESG approach in China. The PRI now has 23 signatories in China, with 14 of these joining in the past year.

Arguably, ESG screening and principles are a sensible way to build an exposure to developing regions that will be too big for investors to ignore. Aviva Investors, for example, does not run an exclusion policy to China, which will continue to power much of global growth in the 21st century, but they will continue to tilt their portfolios to take account of ESG risk. The indices and funds that apply this circumspect approach have a good chance of working best for investors. More importantly, making capital markets encourage businesses to operate in a sustainable and considerate manner is crucial for more than our financial futures.

Box: Fear and opportunity drives ESG awareness

Concerns about sin stocks – such as companies involved in alcohol, weapons and tobacco – are nothing new but ethical screening, once a niche investment option offered by financial advisers, is suddenly mainstream.

So why has the world gone ‘woke’ (the popular term for someone who is thoroughly ‘right on’ and enlightened)? Partly, it’s down to social media disseminating stories about corporate wrong-doing and making it easy to ratchet up peer pressure. Yet, with issues such as population growth, climate change and plastic pollution, there is also a palpable sense the world is at an ecological tipping point and people genuinely have plenty to be scared about.

There is also a more cynical angle. Technology is making it easier than ever before to promote investing solutions to the masses. This coincides with a (justified and welcome) overhaul in regulation of selling financial products and services, and the demise of defined-benefit pension schemes. The net result is a public being encouraged to make their own investment choices despite being chronically undereducated in financial matters. People understand environmental and social issues, which makes services that incorporate these readily grasped concepts a godsend for marketers: doing good with your money is an easier sell than talking about Sharpe ratios.  

One of the many anecdotes accredited to Winston Churchill is that those who aren’t socialist when they’re young don’t have a heart but those who are still socialist when they’re old don’t have a brain. If, however, you believe sustainability goes beyond financial security, then ESG chimes with heart and head. Fintech is enabling millennial investors with little disposable income to save small increments into balanced and ethically considered portfolios, helping the young invest so they have both an income and a planet to enjoy when they retire.