ESG Investing in simple terms

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The investment marketplace has changed dramatically in the last few years with a proliferation of investment approaches variously referred to by one or more of the following titles:

  • Responsible investment,
  • Ethical investing
  • Impact fund investing
  • Environmental, social and governance (ESG) investing,  

The launch of these funds has been accompanied by innumerable articles, in particular on ESG, which can leave the average investor confused, especially when the writers of the articles can have a different take on what the various terms mean.

This article looks to shed some light on their meanings, giving them some historical context, as well as reflecting upon what the future holds in store for investors and investment advisors alike in this brave new world of responsible investing.  Do those that care really win in generating investment returns?

What is Responsible investment?

At a basic level, a responsible investor invests in good companies and builds diversified portfolios which are resilient under various types of market conditions. Conversely, to invest all our money in one stock or in one sector, “to put all one’s eggs in one basket”, could be deemed to be irresponsible.

This definition is focused on the financials, so a “good” company is one that makes money. However responsible investment, as it is more widely interpreted, looks at non-financial considerations and in this wider sense, it is an umbrella term which covers 3 different concepts, each quite different from the other:-

  • Ethical investing
  • Impact investing
  • ESG investing

What is Ethical investing?

Ethical investing is “values” based and has a long history: originally ethics was defined in religious terms; more recently it has been understood as avoiding the “sin” stocks including tobacco, alcohol, armaments and gambling. FTSE launched its FTSE 4 Good index in 2001, which was an ethical investment strategy.  

At the time there was little take-up: partly because the perception was that reducing your investment universe constrained your ability to optimise your risk-adjusted returns. This might be fine for an individual investor but it certainly was not acceptable for institutional investors and fiduciaries who were investing moneys on behalf of other people, beneficiaries such as pensioners who were relying on these investments to fund their retirement.  

What is Impact investing?

Impact investing is a more recent phenomenon where the focus is first and foremost “non-financial” returns. Impact investing aims to generate positive, measurable social and environmental impact alongside a financial return.

So, the non-financial return is prioritised and the question is whether this prioritisation compromises the investment’s ability to deliver above market returns.  For the most part prospectuses make clear  that impact funds prioritise non-financial returns at the expense of financial ones.

However, this is not always the case: for example, an impact fund may have a thematic investment objective, targeting the renewable energy sector. The investment case is the substantial increase in demand for renewable energy as Governments across the world make net zero carbon commitments, and therefore it may be reasonable to be targeting an above market financial return.

Whilst individual investors can make the decision to invest in impact funds whatever their priority, fiduciaries are limited to those targeting the “double whammy” of above market financial returns as well as environmental and/or social impact.

What is ESG investing?

Whilst ethical investing has been around for centuries, ESG investing, like impact investing, is a relatively new concept. However, unlike impact investing which remains a minority sport, it has hit the investment world like a tsunami over the last few years.

In order to identify its first ripples you need to go back to June 2004 when a handful of financial institutions, with AUM of $6 trillion, published and publicly endorsed a UN facilitated report, entitled “Who cares wins”.  

This led, in 2006, to the launch of the UN backed, Principles of Responsible Investment (“PRI”) which put forward 6 principles around Environmental, Social and Governance issues or “ESG” as it is commonly known. Principle 1, the overriding principle states: “we will incorporate ESG issues into investment analysis and decision-making processes”. Signatories to the PRI believed that it made financial sense to analyse how companies managed their material, “non-financial” factors.

At the time it also received fairly short shrift – fiduciaries believed that this somehow compromised their ability to maximise “risk-adjusted” returns and therefore ignored it.

A brave new world?

How times have changed? The PRI is now supported by over 3,000 signatories managing over $100 trillion. Driven, in particular by a realisation that ESG investing could be seen as a long-term risk management framework, the view now is that you are not doing your job properly if you don’t consider these variables.

Environment (“E”):

the climate crisis has thrown up risks which challenge the validity of valuations in corporate financial statements. The concept of “stranded assets” mean that what you thought was a valuable asset might have no value at all. Similarly, litigation threats mean that fossil fuel companies might have material liabilities, not accounted for on their balance sheets. And what about the “inevitable policy response” whereby governments should be taxing carbon polluters who currently do not pay for the “societal costs” which they are responsible for.

Social (“S”):

the corporate world is changing from a shareholder driven to a stakeholder driven approach. It was so easy in the old days – a relentless drive to increase profits and maximise returns to shareholders – Friedmanesque economics of the Chicago school. How much more difficult now for Boards who need to think more about the wellness of their employees, their suppliers, and communities. Again this is not new – the Quakers and chocolate manufacturers of the nineteenth centuries built houses for their employees – they certainly thought about their employees welfare, realising that their interests were aligned as a healthier workforce was a more productive one.

The “fly in the ointment” here is the evidence which shows that index funds who care nothing about the environment, who care nothing about the climate crisis, who care nothing about human rights and whether companies look after their employees or employ child labour, outperform the “average” manager.  

So how does the average investor respond to the evidence? Firstly, the world is changing and people do care; the difference now being that they are more aware. As a result, companies that behave badly are being found out and their businesses, along with their share prices are suffering as a result. Secondly it is incumbent upon investment advisors to select managers who are better than average. In this brave new world they should be focusing on managers who do care.

Perhaps it is not surprising then, as markets are no longer buoyed by falling interest rates and quantitative easing, that we are seeing greater disparities in performance between indices and responsible investment managers. There has been a regime change and, to paraphrase Warren Buffett: “when the tide goes out you discover who is swimming naked”.

So the all conquering S&P 500 is down 10.8% (in sterling terms) for the 6 months to 30th June 2022; whilst the specialist US equity fund manager in Tideway’s manager stable is up 4.2% (in sterling terms), an outperformance of 15%. Is it because the fund manager considers ESG factors? Is it because they are fundamental investors with an eye for earnings resilience? Is it because they are experts in their field who have been analysing corporate performance for over 50 years? No doubt it is all of these things.

In the next few years, it will be interesting to see whether responsible companies who care about the environment, their employees and their communities outperform.  If they do, then investors with specialist fund managers, who invest in these types of company, will be able to sleep well at night, knowing that “who cares, wins”.

Learn more about Tideway Responsible Investment Policy.

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