The acronym ‘ESG’ refers to a broad range of environmental, social and governance criteria which investors are increasingly using to analyse companies alongside traditional financial metrics. Purists may disagree, but ESG has generally come to be understood as a catch-all term for the broader theme of ethically and socially responsible investing. Typical issues that fall under the ESG umbrella include:
- Environmental – carbon emissions, water and waste pollution, resource efficiency.
- Social – workforce diversity, employee health and safety, community engagement.
- Governance – shareholder rights, corruption, reporting transparency.
Richard Mattison, chief executive of S&P’s Trucost, has observed that “the assessment of companies’ ESG profiles has gone from being a ‘nice to have’ to a driver of decision-making”. As public awareness of corporate behaviour rises and governments introduce more regulation, companies and investors are increasingly concluding that sustainable practices make for sustainable returns. This is reflected in the amount of capital being directed towards the space (see chart). Data from Morningstar indicates £4.5bn has been invested in ESG funds in the UK so far this year, with70 per cent of inflows directed towards active funds.
Over £2bn was poured into ESG funds in the third quarter of 2019 alone. And fund houses have been stepping up their efforts to cater to the rising level of interest – 23 new ESG funds were launched this year, compared with just two in 2014. Assets under management in ESG funds reached £35bn this year, having doubled since 2014. Zooming out to the global picture, analysts at Bank of America Merrill Lynch estimate that there could be over $20 trillion of asset growth in ESG funds over the next two decades, almost as much as the current size of the S&P500.
Value versus values
A longstanding debate around ESG investing is whether there has to be some trade-off with returns. Some doubt the ability of such investment strategies to outperform given that they can end up ignoring large swathes of the market. Amazon (US:AMZN) is only included in 37 of the world’s 327 ESG exchange traded funds (ETFs) due to questions around its working conditions – its exclusion from the iShares MSCI USA ESG Select ETF (US:SUSA) has been partly blamed for the fund historically trailing the S&P 500.
At the opposite end of the spectrum from virtuous investing are the ‘sin stocks’ – companies involved in sectors such as weapons manufacturing, tobacco, alcohol and gambling. While the ethics of their activities are questionable, they remain popular among some investors due to their defensive qualities and dividend prospects. The Vitium Global Fund (VICEX) caters to those that continue to spy opportunities in humankind’s vices. It invests solely in sin stocks, such as US defence company Raytheon (US:RTN) and Hong Kong-listed casino operator Galaxy Entertainment Group (HKG:0027). The fund’s managers argue that because such companies are now typically avoided by institutional investors, they are potentially undervalued and could offer higher-than-expected returns.
This is a far cry from the approach of the world’s largest sovereign wealth fund, the £830bn Norwegian government pension fund. It engages in the ethical exclusion of companies from its portfolio and divests from companies that “impose substantial costs on society”. The fund admits this strategy has not come without a cost – product-based exclusions reduced cumulative returns versus its benchmark index by 0.07 percentage points annually between 2006 and 2018. But conduct-based exclusions have provided a 0.03 percentage point annual boost. Though small, this speaks to a wider point made by ESG proponents – sustainable investing can lower your risk profile, reducing exposure to companies engaging in potentially scandal-inducing behaviour.
Negative screening – the avoidance of high-risk companies – is also only one element of ESG investing. More emphasis is being placed on actively selecting stocks that manage ESG risks well. These companies usually operate in long-term growth industries and are seen as the companies of the future. For example, an environmentally-focused ESG approach would probably miss out on any bull run by the oil and gas sector. But as the world transitions to a low-carbon economy, exposure to renewable energy will build a long-term returns profile.
Mona Navqi, director of product management for ESG at S&P Dow Jones Indices, says that ESG investing “is not some virtuous strategy relegated to those investors who are willing to put their beliefs before their returns”. Analysis conducted by investment platform Interactive Investor shows that ethical funds are capable of producing better returns than non-ethical siblings run by the same investment house. Looking at six ethical funds, it found that five of them had outperformed their conventional equivalents in the three years to the end of August, while four also came out on top in the first eight months of this year.
This small study is hardly conclusive, but hints at the potential on offer. The findings also add to a growing body of evidence debunking the myth that ESG investing implies concessionary returns. Joint analysis from Deutsche Asset and Wealth Management and the University of Hamburg conducted in 2015, which looked at more than 2,000 academic studies, found that almost two-thirds of research indicated a positive link between ESG strategies and financial performance. More recently, Morningstar found that 41 of its 56 ESG indices have outperformed their non-ESG equivalents since inception.
This suggests that there is value to be found in values. Speaking on Bloomberg’s Trillions podcast, Graham Sinclair, principal at Sustainable Investment Consulting, expressed a desire to move away from using language like “doing good”. For Mr Sinclair, the ESG approach “is just the way investment will be in the future”.
Avoiding pitfalls
ESG remains a wide umbrella of interchangeable terms. With regulators slow to provide clear-cut definitions, the lack of a single, standardised framework has given rise to varying interpretations of what ESG actually means. For example, index provider MSCI ranks Tesla (US:TSLA) as one of the top US car manufacturers for its ESG credentials. But the FTSE rates it poorly based on the lack of disclosure about the environmental impact of its manufacturing. The lack of clarity can make it difficult for investors to find opportunities that match their investment goals.
The Investment Association recently unveiled its ‘Responsible Investment Framework’, which aims to address this problem in the UK. After consulting more than 40 investment management companies representing £5 trillion of assets, the trade body is hoping the industry will voluntarily adopt its common language to provide investors with greater transparency about what they are investing in. Moira O’Neill, head of personal finance at Interactive Investor, welcomes this important milestone, but remains sceptical of an ongoing “ethical alphabet soup” that is likely to continue confounding investors.
What is deemed ethical or sustainable by one investor will differ from the opinion of another, and the array of investment vehicles on offer cannot individually cater to all tastes. This ties into the issue of ‘greenwashing’, whereby companies and funds’ claimed ESG credentials can be far removed from investors’ expectations. The Vanguard SRI European Stock Fund (IE00B76VTL96) uses “socially responsible” screening criteria, but 7 per cent of its portfolio is in the oil and gas sector, with Royal Dutch Shell (RDSA) and Total SA (TTA) among its top 10 holdings. It comes down to the level of purity you are looking for – for example, if you believe oil and gas companies merit consideration for their investment in the energy transition.
Is green the new black?
More often than not, the long-term success of companies is inextricably linked with the sustainability of the societies in which they operate. Governor of the Bank of England, Mark Carney, warned earlier this year of a “climate-driven Minsky moment” – a sudden collapse in asset prices – as we transition to a low-carbon economy. Mr Carney believes that “if some companies and industries fail to adjust to this new world, they will fail to exist”.
Investors are certainly paying attention. A survey conducted by ETF provider GraniteShares indicates that 30 per cent of UK investors expect the renewable energy sector to perform strongly in 2020 and would put their money there for long-term gain. Investors across all age demographics are bullish on the industry’s prospects, more so than for technology stocks, property or gold. Demonstrating the appetite for green investments, Octopus Renewables Infrastructure Trust (ORIT), which listed on the main market earlier this month, raised £350m from its initial public offering (IPO), £100m more than its original target.
While ESG investing is certainly gaining momentum, should investors be concerned about the hype? “It’s inconceivable that it’s a passing fad,” says Peter Michaelis, head of sustainable investment at Liontrust Asset Management. “The trends and the themes have become stronger over the years, so I don’t see it going away.” The ESG landscape is complex and investors need to do their due diligence. But this style of investing is proving to be more than just philanthropic. ESG can chime with both the heart and wallet and increasingly looks like the smart investment choice.
<BOXOUT><title>Opportunities on offer<title>
Impax Environmental Markets (IEM) invests in companies that provide environmental solutions, with aparticular focus on the more efficient delivery of energy, waste and water services. Top holdings include packaging and recycling company DS Smith (SMDS), as well as Generac Holdings (US:GNRC), a US manufacturer of generators which is expanding into the energy storage market. Outperforming its benchmarks – the MSCI All-World Composite index and FTSE Environmental Technologies 100 index – the trust’s shares have more than doubled over the past five years and are up a quarter so far in 2019. It is managed by IC buy tip Impax Asset Management (IPX), which itself is benefiting from growing demand for its sustainable investing mandates – assets under management increased more than a fifth to £15bn in 2019.
Those looking for opportunities closer to home might consider Liontrust Sustainable Future UK Growth (GB0030028764). The fund posted a cumulative return of 19.5 per cent for the year to the end of October, ahead of the MSCI UK index’s 11.4 per cent, and has also outperformed across longer time periods. Its top holding is Irish construction materials company Kingspan (KGP), which produces insulation and building envelopes, which improve energy efficiency. After financial services, the second highest sector weighting is towards healthcare and includes IC buy tip GlaxoSmithKline (GSK).
With governments, consumers and investors increasingly focused on corporate safety, quality and sustainability, companies are having to grapple with rising ESG-related regulation. This bodes well for Intertek (ITRK), which provides assurance, testing, inspection and certification services. The group estimates that the global quality assurance market is worth around $250bn and 80 per cent of the work is still conducted in-house. A new ‘total sustainability assurance’ initiative aims to provide an industry standard that verifies companies’ ESG credentials against Intertek’s criteria.
A recent trading update suggests the company is on track to deliver full-year expectations and, although the shares are trading at 25 times forecast 2020 earnings, we see a long-term growth opportunity.<boxout>
