19 Feb Opportunities to leapfrog in Emerging Markets
– Andrew Hardy, CFA
Nobody could have missed the global awakening to the debate on climate change over the past year. The greater frequency of extreme events – fires, storms, flooding – as well as the increased visibility of movements like Extinction Rebellion have been key driving forces behind this, although the heightened attention is long overdue. Within the investments industry this has translated into a marked increase in demand for strategies that focus on sustainability; an inexorable trend that the whole industry needs to adjust for.
The investment jargon is confusing, with lines often blurring between SRI (Socially Responsible Investing) and ESG (Environment, Social, Governance) funds, although all have a focus on investing in “good” companies, supporting “good” causes. However, scrutiny from investors and regulators is leading to improved clarity and transparency around the underlying definitions and processes. In order to use a more standardised ESG compass many investment managers have adopted the Principles for Responsible Investment (UNPRI) guidelines, which were developed in 2004 through a joint initiative led by the United Nations1 and formally launched in 2006. Today the UNPRI has over 1,000 signatories representing over $70 trillion of assets under management. Estimates of total assets invested in dedicated ESG strategies vary but we know it is a relatively small share of total AUM at present which we can be certain will continue to grow.
As well as the ethical imperative, there has been greater recognition of the financial imperative of a sustainable investment approach. For instance, research by BofA Merrill Lynch recently estimated that buying stocks that rank well on ESG metrics outperformed the market by 3% per year and could have helped avoid 90% of recent bankruptcies in the US2. Ultimately, these “better” companies should be rewarded with lower costs of capital and their investors should benefit from reduced risks in their portfolio.
So, the question for 2020 is not ‘if’, or ‘when’, but rather ‘how’? It is recognised that ESG considerations go well beyond just carbon emissions, to encapsulate a plethora of other controversial activities – from deforestation or use of plastics, through employment practices including child labour and gender inequality, to independence of board members and proxy voting – all factors that represent real risks for businesses that must be better incorporated into investment decisions. In order to do so investment managers should adopt an integrated approach, with ESG issues assessed across every aspect of the process. The explosion in data availability around all these factors will generally help to facilitate this, but given the complexity and inter relatedness of many of these issues, the qualitative human element that comes with actively managed strategies will arguably have an edge over rules based, passively managed strategies here.
Excluding investments in businesses that operate in controversial sectors can also help, but only to an extent. Selling one’s shares in a business simply passes ownership and voting responsibility on to the next holder, who may be less attuned to sustainability issues and less inclined to help drive change in these companies and sectors. Instead, engaging and holding on to investments in businesses that are willing to change their practices for the better with an intent to transition to a more sustainable approach may be the more effective strategy. Second derivative exposures must also be considered – rather than just excluding investments in thermal coal producers for example, one must consider the secondary industries feeding their sales – energy companies and national grids, power plants and the like. Furthermore, consideration must be given to the communities that depend on such industries for their economic livelihood, which speaks to the ‘S’ of ESG. Hence, what is deemed a “good” or a “bad” company or even sector from an ESG perspective is not always absolute, and needs careful consideration.
¹ ‘Who Cares Wins. Connecting Financial Markets to a Changing World’ – United Nations Global Compact, June 2004. ² ‘10 Reasons You Should Care About ESG’ – Bank of America Merrill Lynch, September 2019.