Increasing fund flows are leading ESG investors to raise the bar
Surging interest in ethical investing is increasing the expectations of ESG investors. This is creating a challenge for portfolio managers in a fast-growing but ever more demanding marketplace.
Environmental, social and governance (ESG) investing is no longer a new concept or even a differentiator for investment managers.
ESG investing is being considered by an increasing number of standard investment funds. Dedicated ethical and ESG funds are seeing fund in-flows, especially from superannuation schemes.
However, as ESG investors have a wider range of investment choices, their expectations beyond attractive risk-adjusted returns are increasing.
In this article, we look at some areas that ESG investment managers must focus on if they are to meet clients’ rising expectations.
Aligning with investors’ values
ESG investing has moved from addressing a niche market to being a key part of the investment process. This reflects, at least in part, a generational shift as millennials expect that their savings will be invested in a way that aligns with their values and beliefs.
These investors approach their financial planning from the starting assumption that returns should not depend upon company earnings derived from activities such as exploitation of child labour, processes that pollute the environment or operations that contribute to climate change.
ESG investors expect managers to establish an investment process which, at the very least, is able to successfully navigate the ESG pitfalls that periodically hurt many standard funds. Qualitative analysis and company engagement are likely to be more effective tools than data-driven screening, which tends to be backward-looking and based on company disclosures. In practice, attractive risk-adjusted returns and strong ESG credentials that align with investors’ expectations require an actively managed approach.
Pursuing engagement that delivers a positive impact
A negative screening process that simply excludes those companies with the weakest ESG credentials is a necessary but no longer sufficient approach to investing with consideration to ESG issues. Investors are increasingly expecting portfolio managers to demonstrate that they are having a positive social impact as well as delivering a financial return.
This necessitates an ongoing program of engagement with companies, government bodies and other stakeholders to make a difference in those priority areas that the fund manager has identified. This might be a handful of issues each year, on which the manager would be expected to measure and report progress.
Increasing the level of ESG transparency
Investors are also expecting investment managers to provide clear and ongoing communication that delivers clarity on their key ESG concerns. This applies not just to ESG-focussed products but also to standard funds.
Investors expect a very clear stance on the key ESG issues which are then shared with the market, not just through regular communication but also by a manager establishing a reputation for thought leadership in its chosen space.
Showing how exclusions impact returns
ESG funds are established with the intention of performing at least in-line with, and preferably exceeding, their associated standard market benchmarks over the long-term. Yet an ESG fund manager will typically exclude 10-20% of its investment universe through its screening process. This will inevitably give rise to significant short-term variation in the fund’s performance relative to that of the market benchmark.
Companies that are most likely to be excluded by a manager’s ESG screens and investment process include those focussed on gambling, alcohol, mining, tobacco, energy and manufacturing weapons systems.
The exclusion of these sectors means that an ESG fund may perform differently to a standard fund that tracks the standard benchmarks at certain times in any economic cycle.
Investors who have been ‘sold’ the prospect of market-level returns over all time horizons should be guided through periods of variation with an explanation of how the exclusions and positive tilts are impacting relative returns.
Demonstrating the benefit of an inherent style bias
A focus on sustainable business models rather than near-term earnings growth tends to deliver an inherent bias in style towards quality and value at the expense of some growth stocks.
Value and growth investment styles perform differently at various stages of the economic cycle so ESG funds with these biases will perform differently to a diversified style at different times in a full market cycle. This style risk is managed in practice by many conventional active equity managers who attempt to ‘tilt’ their investment style to best capture return opportunities, or multi-manager strategies that seek a diversified return from different ESG managers.
Over the long term, the return differential can be expected to be eliminated, simply because ESG funds typically select companies with sustainable earnings and seek to avoid stocks that suffer the most dramatic underperformance shocks.
Delivering a turnkey solution
ESG retail and superannuation investors share many characteristics with those who normally invest in standard funds. Most long-term savers expect a relatively low-maintenance investment experience and are attracted by an end-to-end solution that delivers returns in alignment with their long-term financial goals.
They expect a straightforward experience in which they can invest up to the total value of their superannuation plan or other long-term savings. This includes a dashboard that enables straightforward and instant valuations and account management.
While every care has been taken in the preparation of this article, AMP Capital Investors Limited (ABN 59 001 777 591, AFSL 232497) and AMP Capital Funds Management Limited (ABN 15 159 557 721, AFSL 426455) (AMP Capital) makes no representations or warranties as to the accuracy or completeness of any statement in it including, without limitation, any forecasts. Past performance is not a reliable indicator of future performance. This article has been prepared for the purpose of providing general information, without taking account of any particular investor’s objectives, financial situation or needs. An investor should, before making any investment decisions, consider the appropriateness of the information in this article, and seek professional advice, having regard to the investor’s objectives, financial situation and needs. This article is solely for the use of the party to whom it is provided and must not be provided to any other person or entity without the express written consent of AMP Capital.