Environmental, social and governance (ESG) issues are increasingly guiding portfolio construction. However, taking an ESG approach can introduce new risks. Chris Kennedy reports.
Concerns remain about the benefits of an environmental, social and governance (ESG) approach to investment, partly due to the increased investment cost and also the potential to shift the risk profile of a portfolio.
In a recent analysis of AMP Capital Investors’ sustainable funds strategy, Morningstar senior research analyst Julian Robertson said that the focus on ESG could push out many larger cap and more defensive stocks, increasing the risk profile.
This is partly because it can be harder to analyse the governance of larger conglomerates, because when you try and apply the ESG approach to individual companies it results in many of those larger stocks falling out of the portfolio.
The universe then gravitates towards the smaller end and mid cap stocks, he said.
An ESG filter also removes many companies with exposure to uranium (and other mining), gambling, alcohol, tobacco and armaments – and these can often be larger cap and defensive stocks, Robertson said.
The resulting portfolio is cleaner in terms of being able to analyse the ESG practices of companies, he said.
AMP Capital’s new head of sustainable share funds, Dr Ian Woods, has been involved with the strategy for the 10 years since its inception.
He said that while the ESG focus had contributed to the fund’s underperformance over the past 12 months, over three to four years it had boosted returns.
“It’s not whether it’s a smaller pool of companies to invest in, but do you have a better pool of companies to invest in? Over three to four years that pool of companies has performed better than ASX,” he said.
Companies that do better on ESG factors tend to perform better overall, he added.
AMP Capital’s sustainable funds take a slightly different approach to ESG filtering. Rather than striking off stocks or sectors with suspect ESG criteria, the strategy applies higher governance hurdles to companies that operate within sectors that tend to be red-flagged in terms of governance, such as mining.
For example, a mining company would have to satisfy more stringent ESG criteria, and would be expected to do more to manage their environmental risk compared to a telecommunications company, Woods said.
Making adjustments
In terms of managing the risk profile, Woods said there were few companies on the ASX200 that were completely excluded, but often it was also possible to maintain exposure to a particular sector by investing in a different company.
So if the team decided that Woolworths did not pass ESG hurdles, the fund could maintain exposure to the retail sector through another company such as Wesfarmers or Metcash, he said.
Bill Hartnett is the sustainability manager at Local Government Super, one of the most proactive super funds in the country when it comes to responsible investment.
Hartnett does not feel that the potential for an ESG screen to shift the risk profile of a fund needs to be a factor, because there are enough options in terms of companies to run a fund without ending up underweight to defensive stocks or a particular sector.
There is no disputing that adding a layer of ESG research adds to the overall investment cost, whether that is done internally or through purchasing external research from a provider such as Regnan that LSG subscribes to.
But Hartnett believes the benefits to a portfolio outweigh the extra costs.
“[ESG research] has been a performance enhancement for us and the additional costs are made up for in a holistic evaluation of stocks,” he said.
Helga Birgden, Mercer’s head of responsible investment for Asia Pacific, said that clients see ESG as an area of both risk and opportunity, adding that it is important to integrate risk management mechanisms when building a portfolio.
ESG is not necessarily a penalty, and the investments should stack up on a traditional risk return basis, she said. It is difficult to generalise and say that an ESG approach will necessarily reduce returns, she added.
An ESG approach can also help identify other drivers of risk; for example, companies that are exposed to climate change risk, she said.
Climate change
The major theme of climate change is an area that requires good governance. It is important not to look at it narrowly in terms of whether or not you are investing in green real estate.
Rather, you should ask if the portfolio as a whole is managing risk with regards to the new issues that climate change is presenting to investors all over the world, Birgden said.
Managers need to understand the impact on their portfolio if they have a high exposure to infrastructure such as ports, airports and roads, and if there are ways to make those investments more resilient to climate change risk, and also consider major thematic stresses on economic activity in portfolios, she said.
Depending on the type of portfolio an investor is looking for, smaller cap stocks tend to predominate, and clients looking for sustainably themed investments would find more on the unlisted side, which could also contribute to a smaller cap weighting, she said.
However, if a manager was integrating ESG into a fundamental bottom-up analysis that would be less likely to be the case, she said.
When looking at ESG investments it is important to choose a manager that has superior ideas and can implement them right through the portfolio construction and management process in the ESG area, Birgden said.
You need to be confident they are constructing the portfolio in a way that’s true to these ideas, as well as managing the risk well, she added.
A 2009 Mercer review of academic studies found that 10 of 16 studies identified a positive relationship between ESG factors and a company’s financial performance, while two of those studies found a negative relationship.
Of four studies looking at the effects of environmental factors, one found a positive relationship between environmental factors and company value, while overall, Mercer noted the financial community assigned more value to environmental factors within high environmental risk industries.
Four studies investigating the effects of social factors on financial performance found overall that improved social performance of companies within an investment portfolio can lead to improved financial returns.
Four studies examining the effects of governance factors also found that strong and actively promoted corporate governance had a positive impact on firm and portfolio performance.
Further studies examining the impact of screening out ‘sin’ stocks such as tobacco and arms also found mostly neutral or positive effects, according to Mercer.
“The results are leaning in favour of the value-added proposition of ESG integration,” Mercer concluded.
Aside from the potential return benefits, Birgden said there is increasingly an overall trend towards ESG integration due to client demand, because clients want to know how mainstream portfolios are managing ESG risk.
Investors see ESG as an area of portfolio resilience in terms of long-term risk versus reward, she said.
“ESG is very much part of world we live in and the way companies operate,” she said.
