Portfolio Managers Michael Keough and Brad Smith discuss the growing importance of active management in sustainable investing, highlighting the potential benefits that can be realized in returns, risk management and the ability to influence companies’ sustainability practices through active engagement.
The UN recently came out with a code red designation for climate change, stating that climate change is undoubtedly man-made and the urgency for addressing the issue is increasing.
We believe active management in sustainable investing is crucial because ESG analysis should be forward looking while ESG ratings are predominantly backward looking.
Additionally, through engagement with issuers, active managers can advocate for greater transparency and the adoption of more sustainable business practices.
Why is sustainability analysis growing in importance?
Brad Smith: It’s no surprise to anyone today to hear that the impact of climate change is becoming ever more present in our day-to-day lives. From the heat waves that we are experiencing across the country to devastating forest fires faced in California to the smoke plumes that are hanging over this beautiful state of Colorado and polluting the air we breathe – the effects are hitting home. The UN recently came out with a code red designation for climate change, stating that climate change is undoubtedly man-made and the urgency for addressing the issue is increasing. So, the time is now to ensure your investments are part of the solution, and not perpetuating the problem.
But even if these issues don’t stir you, we believe that sustainable investing is a better lens through which to analyze financial investments and generate more resilient returns. What is undeniable, is that environmental and social change are morphing the fabric of our economic system. We believe that this transition creates a generational shift for investors to capture the opportunities that this transition creates, and more imperatively, avoid the disruption that will inevitably occur as companies who have failed to future-proof their businesses bear the consequences.
Why is it important to consider sustainability now?
Smith: We’re seeing companies in a rush across the economy to make the drastic shifts required to set the world on the right path to navigate the significant issues that we face, like climate change, resource constraint and inequality.
And so, while some companies face risk in this transition, the opportunity is also massive. The UN has estimated that a $12 trillion market opportunity will be created by 20301 as the world invests to meet its sustainable development goals. Investing with companies that have aligned with those goals is one way to capitalize on this opportunity.
The global drive to decarbonize is causing a shift in capital investment and it creates risks for those companies or industries that fail to adapt, while it creates massive opportunity for those who anticipate and invest to stay on the right side of this economic shift. Within carbon-intensive industries like utilities, we see bifurcation between corporations making significant strides to reduce carbon footprint and make the shift towards renewable energy, while others are slow to react, which we believe will raise their relative cost of capital in the future.
Why is active management important?
Michael Keough: We think that active management in sustainable investing is crucial and there are two main reasons why: first, ESG analysis and ratings should be forward looking, and second, it allows for the engagement on issues with the companies that you invest in.
A principal belief for active managers is that there’s the ability to conduct research and anticipate something that’s not reflected in the price of a security today but will be in the future. And we believe that is true for environmental, social and governance risks.
Third-party ESG providers predominantly focus on what the issuer’s done in the past and not what they expect them to do in the future, and we believe that investors need to anticipate how these trends are going to play out – the impact on the companies you invest in. Will it help or hurt their earnings? What’s going to happen to the valuation of their securities? There will be winners and losers, and forward-looking ratings help position portfolios for that.
And the next reason is engagement, or how active managers have investment teams that can interact with the companies that they invest in and their management teams. And as part of that engagement and interaction process, you can act as an advocate for greater transparency for the adoption of more sustainable business practices which can influence a company to have more positive sustainable outcomes.
Are companies that lag in their transition to sustainability at greater risk?
Smith: Avoiding downside risk is one of the biggest drivers of returns for a bond manager. ESG risks often linger in the background but can impact security prices abruptly and dramatically when controversies arise. Disruption is often one of the most difficult situations for a company to overcome. We’ve seen the costly effects of disruption play out quite recently in places like brick-and-mortar retail, which has faced market share loss as a result of the rise in online retailers. There, we saw a large number of bankruptcies in those companies that failed to adapt to the changing economic system.
One of the places where we see opportunity to invest is at the inflection point of change; looking for companies that may not have fully sustainable practices today but have a credible plan to address their shortfalls and the capital capacity to do so.
1Source: Business and Sustainable Development Commission, Better Business, Better World, 2017
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