Principles of ESG Investing: the carrot, and the stick
Investing with reference to environmental impact, social impact, and good governance (ESG), has become an increasingly relevant topic over the last few years, especially in developed markets amongst institutional and retail investors alike - this trend shown with assets under management in ESG funds growing by 53% in 2021. Developing markets like South Africa have lagged, although even this is changing - attending any shareholder event or meeting with company management you will be bound to hear about their progress with ESG initiatives, and in December 2021, the JSE launched its Sustainability and Climate Change Disclosure Guidance papers to guide its listed companies' ESG disclosure and help companies align to global standards.
At its heart, ESG is about being responsible stewards of capital taking a view beyond purely profit, acknowledging the impact that capital allocation can have on society and the ecosystem around us.
FirstRand is aligned this concept of shared prosperity, and at FNB Wealth & Investments, we believe in an authentic approach to ESG rather than a reductive exclusionary approach that could result in “ticking boxes“ rather than a holistic consideration of the broad impact that investment, or disinvestment, can result in.
Doing business better
In the context of investments, taking ESG factors into consideration involves a broad-based evaluation of the role that capital allocation can play in generating a positive social & environmental impact beyond just returns on capital. Labour practices, board diversity, protection of customer data, and conservation of our planet are just some of the many ESG factors that, firstly, are here to stay (and will only grow in importance as the global economy matures), but secondly, are all factors that ultimately serve to benefit stakeholders over the longer term. Governments and listing authorities are increasingly clamping down on companies who illustrate non-compliance with principles like these, highlighting one potential cost of not considering ESG factors: increased regulation, and increased regulatory costs . Identifying companies making positive strides towards their overall societal impact is a nuanced task, with no one template fitting all companies, or even all industries, but at the heart of ESG is simply doing business better - and the value creation that comes with that. A vital part of doing this is appropriate Governance - perhaps the most important component of ESG, since a company's governance determines the strategic direction of a company, ultimately affecting how they go about doing business and creating long-term shareholder value, and why evaluating governance risks is deeply ingrained in our fundamental equity process.
Forget what's on the box, what's in the tin?
With the proliferation of ESG funds, ETFs, and ranking systems unfortunately has also come confusion over how to accurately rate companies in terms of their ESG favourability. A technology services company can't be rated on the same set of factors as a mining company, and when buying an ESG product that is constructed based on a set of rating rules, such as an ETF, careful attention needs to be paid to the unintended biases that may be introduced from these rules - such as skewing the product towards capital-light tech companies, the resultant product being a tech-biased investment rather than a product explicitly geared towards future social & environmental value creation.
Investing in ETFs is another craze that has taken off in 2021 - with over 1500 new ETFs launched, compared to the previous record of 873 in 2018 , while Figure 1 below shows how the number of funds specifically with an ESG focus has grown more than fivefold in the US. At the intersection of these two themes, when using a passive investment product for its ESG claims, it's important to understand how the product provider decides on which companies to include (and whether those rules skew the product towards certain industries), and when looking at the historical or back tested performance of the ETF, figuring out what has driven that performance.
As part of a recent strategic asset allocation review for one of our product lines, we did in fact consider the inclusion of a passive investment offering with an ESG mandate - one advantage of a passive product being the lower cost at which they are typically offered. While it screened well on a retrospective basis, on further inspection we discovered a heavy tech concentration which had driven most of its outperformance over 2020 and 2021 (and its subsequent year-to-date underperformance). We ultimately elected not to include the offering in that portfolio offering due to this sectoral tilt that resulted from the rating methodology, and the lack of a significant benefit from a portfolio construction perspective.
California-based Research Affiliates LLC conducted a study into ETF performance, finding that ETF providers often launch new products based on the winning streak that the back tested returns show - while after launch the average ETF goes on to provide 0% excess return to investors (see Figure 2). As the famous disclaimer goes, past performance does not guarantee future returns - and when buying an ETF, especially a thematic one, it's vital to look past the “label“ and understand what you're actually investing in. Highlighting this point: earlier this year Morningstar removed their ESG tag from more than 1,200 funds, after finding fund managers were making misleading claims about the extent to which ESG is integrated into their investment process. As the buzzword continues picking up pace, greenwashing will be something to continue to avoid, and something investors should look out for - by understanding the underlying product.
Our approach
Incorporating ESG in our investment decisions doesn't involve a pure exclusionary approach - restricting investment in certain companies or sectors, but rather a holistic evaluation of a company's specific ESG profile. Our view is that a narrow exclusionary approach can be reductive - for instance, if oil companies receive little public market support, raising their cost of equity, they may eventually choose to delist, finding it easier to raise capital in private markets. One result would be that disclosure requirements of listing exchanges would no longer apply to them, leaving them more at liberty to not take environmental impact into consideration - and another result being that shareholders would have no ability to influence management decisions here. Engagement with company management is the metaphorical carrot, while disinvestment is the stick.
In our holistic approach, we look at elements of company governance, such as board composition, executive diversity and remuneration incentives, all of which can highlight ESG risks - with all such risks factoring into our discount rates, impacting valuations and potential upside we see in companies. Where we do see ESG risks arising in companies we are invested in, we prefer to exercise our fiduciary responsible through engagement rather than through disinvestment, believing that this can create more optimal outcomes for shareholders and for all stakeholders. Where we do invest in contentious industries such as mining, we prefer highly regulated companies, considering the broader impact. Baillie Gifford's note “Rio Tinto - controversial investment, or central to driving progress?“ makes the point that a transition to renewable energy relies on the mining of iron ore, aluminium, and copper, and their engagements with company management have afforded them the opportunity to suggest improvements on sustainability issues. “Dirty mining“ is a necessary evil on the transition to clean energy - and thoughtful allocation and management of capital can play a key role in ensuring this is done responsibly and with minimal environmental damage.
How we see ESG evolving
Despite its proliferation in company reports, listing exchange requirements, and new investment offerings being brought to market, ESG is a relatively new concept in the world of financial markets. With that has come great uncertainty and disparity between investors in how best to measure whether a company rates highly when it comes to ESG factors, the Morningstar ESG label example highlighting how measurement is still evolving and as yet there is no single “correct“ approach.
We see measurement and disclosure standards, together with greater consistency across metrics, as being a key area of improvement that will unfold in the years to come. Including an ESG-focused asset class in our portfolios won't be done simply due to an ESG label - our focus is still on providing strong outcomes-based solutions, and when considering ESG investments we place careful due consideration on the potential benefits and risks the asset will bring from a portfolio construction perspective, with the fundamental principles of ESG investing ingrained in our thinking rather than being a post facto tick of a box.
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