Demystifying ESG: creating a clear investment case
One of the pitfalls of there being multiple ways to interpret sustainability in the context of an investment process or strategy is confusion and misunderstanding among investors.
It makes sense that the best investment returns will be generated by those companies providing solutions to environmental and social challenges. Yet it is when investors start to explore how to achieve this that things can stall.
Our approach is rooted in a 30-year old definition of sustainability. The UN-commissioned Brundtland Report in 1987 classified it as “development that meets the needs for the present without compromising the ability of future generations to meet their own needs”. We look to incorporate environmental and social considerations throughout the investment process – from idea generation to portfolio construction and management.
For many investors, however, the first step is to understand how to think – and, equally importantly, how not to think – about sustainable investing, and how to assess and incorporate ESG factors.
Demystifying a sustainable strategy
We see four key elements of how many investors view ESG considerations within their portfolio:
- Managing risk
- Driving corporate change
- Avoiding doing any harm
- Helping to do good
First, taking a risk management perspective is natural as investors want to avoid blow-ups to generate better risk-adjusted returns. Yet this is mainly just operational ESG analysis. We don’t see this as making a particular judgment on any particular industry. For any long term investor looking for compound growth, capital appreciation and wealth generation, it is important to back a good management team. Conducting fundamental investment research to gain additional insight into specific ESG factors influencing an individual company and its industry or sector is essential as part of assessing the risk of impairment to the value of the asset/company.
Second, some investors try to foster positive change in companies with underlying issues by ‘turning them around’ from an ESG perspective to realise value. However, engagement is not just about making bad companies good, plus such an ‘activist’ approach is difficult for many investors to achieve. Instead, we target companies with high standards, although we still recognise the importance of being an ‘active’ investor, given there are always some ESG factors which can be improved. As a result, it is about finding companies that are open to being collaborative. Such a ‘partnership’ style of engagement enables us to influence positive change towards environmental or social issues.
Third, some investors might look to apply ESG factors in a strategy so that they can ensure they do no harm. They do this by deliberately avoiding allocating capital to companies that cause problems for the environment or society through their products or operations. However, the reality, we believe, is companies that do such environmental or social harm are at greater risk from regulation or hidden liabilities in the future.
Fourth, some investors use ESG factors as a lens of opportunity through which to make positive change. They seek companies on the right side of environmental and social trends through goods and services that are in growing demand because of the benefits they provide in facilitating a sustainable global economy. This presents a big investment opportunity, but only assuming investors actively look to implement their convictions.
In general, investors often look to apply concepts and processes from each of these four approaches in different ways across various investment strategies.
From our standpoint, we see four ‘pillars’ of a sustainability driven investment strategy. This is based on the realisation that there are often conflicts between environmental and social sustainability, so we seek to address this by using both positive and negative (avoidance) investment criteria, plus considering the products and operations of a business.
This demands active management; allocating passively to companies identified as having the potential to thrive due to their positive impact is akin to abdicating responsibility as a socially responsible investor.
Please read the following important information regarding funds related to this article.
- Shares/Units can lose value rapidly, and typically involve higher risks than bonds or money market instruments. The value of your investment may fall as a result.
- Shares of small and mid-size companies can be more volatile than shares of larger companies, and at times it may be difficult to value or to sell shares at desired times and prices, increasing the risk of losses.
- The Fund follows a sustainable investment approach, which may cause it to be overweight and/or underweight in certain sectors and thus perform differently than funds that have a similar objective but which do not integrate sustainable investment criteria when selecting securities.
- The Fund may use derivatives with the aim of reducing risk or managing the portfolio more efficiently. However this introduces other risks, in particular, that a derivative counterparty may not meet its contractual obligations.
- If the Fund holds assets in currencies other than the base currency of the Fund, or you invest in a share/unit class of a different currency to the Fund (unless hedged, i.e. mitigated by taking an offsetting position in a related security), the value of your investment may be impacted by changes in exchange rates.
- When the Fund, or a share/unit class, seeks to mitigate exchange rate movements of a currency relative to the base currency (hedge), the hedging strategy itself may positively or negatively impact the value of the Fund due to differences in short-term interest rates between the currencies.
- Securities within the Fund could become hard to value or to sell at a desired time and price, especially in extreme market conditions when asset prices may be falling, increasing the risk of investment losses.
- The Fund could lose money if a counterparty with which the Fund trades becomes unwilling or unable to meet its obligations, or as a result of failure or delay in operational processes or the failure of a third party provider.
- In respect of the equities portfolio within the Fund, this follows a value investment style that creates a bias towards certain types of companies. This may result in the Fund significantly underperforming or outperforming the wider market.