There are a lot of acronyms in the investment industry. And there’s one that has a lot of momentum right now – and which has been increasingly fascinating to Michael Bull (pictured), Executive Director, Jersey office, at Quilter Cheviot and his colleagues – ESG
ESG stands for environmental, social and governance, and it is having a huge impact on both investing and the wider corporate world. These three little letters represent a momentous shift in attitudes and business practice. But what does it all mean?
This is the starting point for understanding how the responsible investment process works in practice.
ESG issues are data points that can be used as an additional input into the investment analysis process. This information can often be qualitative and is not the kind of information that tends to be discerned from traditional financial statements or three-year earnings forecasts.
So what does this mean in practice? From an environmental perspective, it could be looking at how an oil company is creating a climate transition pathway and the targets and timeline that has been set for this.
From an S (social) perspective, this might involve – as it has done so far in 2020 – thinking about how a company is treating its employees in a Covid-19 environment. For example, are there proper social distancing measures in place where employees don’t have the luxury of working from home?
From a governance perspective, this would include the remuneration policy for the executives and board diversity (is it all the same school tie?).
When these factors are taken into account within the investment process, we call this ESG integration.
The key message is that this is a process that analyses ESG data to help inform investment decisions, to ensure that all relevant factors are accounted for when assessing risk and return.
This is an extra source of information, an additional input that supplements the traditional analysis of financial data, and should ultimately lead to better informed investment decisions – when done effectively.
How do sustainable investment funds differ from ‘normal’ funds?
Morningstar reports that there are now nearly 4,000 sustainable investment funds, reflecting the many different approaches to sustainable investing.
Some funds focus on themes, such as the environment or education – or a combination of different ESG-related themes. Other funds give a higher weight to companies with better sustainability profiles and a lower weight to companies with weak ESG practices. Other funds look to invest in companies that make a positive contribution to the environment or society.
Some sustainable funds exclude certain areas, such as tobacco, armaments, alcohol and fossil fuels. Others invest across industries. There is no one definition for what investing sustainably means.
Sustainable investment funds can be quite similar to ‘normal’ or mainstream funds in how they are structured and managed.
However, the investment objectives of these funds can be different. A sustainable investment fund may, for example, have a dual objective, targeting both a positive contribution to society and the environment, as well as a traditional benchmark. Or the fund may have a customised benchmark to reflect the universe of companies it is targeting – or perhaps the fund will only target a positive contribution.
Meanwhile, many ‘normal’ funds now incorporate ESG factors within their investment process as well. This does not mean that they are sustainable investment funds or that they exclude parts of the market on value-based considerations, such as avoiding animal testing or armaments.
The growing number of these funds that are integrating ESG factors into their investment processes is being driven by the soaring popularity of sustainable investments, new regulations relating to ESG that lie ahead for the investment industry, and the growing appreciation of why ESG factors are important risks to consider.
In the end, it is not considering ESG factors within investment processes that determines whether a fund is billed as a sustainable investment fund or a mainstream/‘normal’ fund.
Instead, it is whether the fund manager then uses that ESG data to be fully informed of the potential risks to an investment (a mainstream fund); or uses it to bias or focus the fund towards companies that score well on whatever ESG metric is being favoured; or to favour companies with products or services that reflect the fund’s chosen sustainable themes (a sustainable investment fund).
How Quilter Cheviot approaches ESG in its fund research process
To date, 2020 has helped add weight to the view that there is no need to sacrifice financial returns to invest sustainably.
Sustainable funds have performed relatively well in the downturn, as well as in the subsequent market rally.
At Quilter Cheviot, we firmly believe that integrating ESG considerations into our investment process helps us protect and enhance long-term investment outcomes for our clients.
Therefore a growing consideration within our fund research team’s investment process has been how third-party fund managers approach ESG risks and opportunities as part of their investment decision-making.
The fund research team is assessing its list of Buy and Monitored rated fund managers, as well as new managers, on the extent to which ESG factors are being incorporated in an explicit and systematic way. The approach will often vary by asset class and whether the investments are active or passive.
Our analysts also assess the extent to which the fund managers are engaging with company management teams on ESG issues.
There is a high degree of variation in progress made to date on ESG integration. Some third-party fund managers are only just acknowledging the importance of ESG issues within their investment process.
But many fund managers are adapting their investment processes rapidly to include ESG factors within their analysis, valuation and stock selection.
Others have been formally incorporating ESG considerations into their investment process for years. This means the task for the fund research analysts is not just to assess the extent to which the fund manager and analysts are thinking about ESG issues today, but also to consider how well they will be doing it in a year’s time.
With many fund houses racing to establish their ESG and sustainable credentials, the fund analysts use their one-to-one meetings with fund managers to try to get past the persuasive marketing and potential greenwash – when funds are made out to be greener than they are – and understand the true drivers of investment decision-making.
Where we see ESG going from here
Given the massive implications for the global economy of issues such as climate change, we think the growing demand for companies to have better sustainability practices, and for companies with products or services that offer solutions to environmental or societal problems, is only going to accelerate.
Whether or not companies producing environmental solutions will always outperform benchmarks is a different question.
But the increasingly evident need to include ESG factors alongside traditional financial criteria in order to make fully informed investment decisions is only going to bring ESG issues more and more under the spotlight.
I see this as a welcome area of development in the industry that is only set to continue.
For more information please contact:
Sophie Gorman, Quilter Cheviot
E: sophie.gorman@quiltercheviot.com
T: +44 (0) 20 7150 4246
• This advertising feature was first published in the October/November 2020 edition of Businesslife magazine