Responsible investment – what are you waiting for?

Responsible investment hasn’t exactly taken off in the planner space despite the advent of cheaper products and easier access. Bela Moore reports. 

By most reasonable standards, investing is undertaken with a view to taking more money out at the end than is originally put in. 

For a planner to recommend a product that returned less than was initially invested, or promote an investment where returns were uncertain, would be counter-intuitive.  

In the face of the typical rhetoric undermining responsible investment in the retail space, institutions have significantly increased the management of their investments’ environmental, social and governance (ESG) risks in a bid to better manage risk and secure long-term returns. 

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Responsible investment and ESG are being managed as a core risk, not only in traditional equity markets but across other asset classes as well.  

Fashion, fiction or real returns? 

While the institutional world begins to embrace responsible investment in expectation of good long-term performance, Responsible Investment Association of Australasia (RIAA) chief executive Simon O’Connor said performance is still under-rated in the retail space. 

“That myth of underperformance is still alive and well,” he said. 

Responsible investing has been stigmatised by negative press, and responsible investors have often been accused of prioritising the ‘feel good factor’ over performance. 

Dalton Nicol Reid chief executive and director Harley Dalton said original market participants – deep green funds – had encouraged a negative image of responsible investment funds. 

“That’s where this constant stigma is attached to the idea that it’s costing you performance,” he said. 

“If you go into quite a thin wedge of the markets, and there’s participants that will go down that path, as a business owner and investor, it comes back to ‘you invest money to make money’.” 

O’Connor said “false” distinctions between types of responsible investments were breaking down. However, the myth is “alive and well”. 

“Compared to mainstream funds, last year’s (2011) report showed that responsible investment funds outperformed across every category and over every time horizon.” 

According to RIAA’s 2011 annual benchmarking report, the average responsible investment balanced fund option returned 9.8, 2.19, 2.81 and 7 per cent over one, three, five and seven-year time frames, compared to 7.65, 1.97, 1.80 and 4.58 per cent for the mainstream equivalent.

Performance depends on the quality of the stock-picker and, as with every fund type, there were good and bad managers, but on average those in responsible investment outperformed, O’Connor said. 

“If these investors are doing more research for every investment decision, then you would expect outcomes and performance to be better,” he said. 

Premium Wealth Management chief executive Paul Harding-Davis said the GFC had shown how resilient responsible investment funds could be during a market downturn. 

“They have an equivalent risk-adjusted return, but they tend to do better in down markets and I think it’s that longer-term focus,” he said. 

In February 2009, during the worst performance of the GFC, Australian Ethical’s smaller companies trust, which invests into the small industrials industry, returned -15.3 per cent compared to the ASX200 benchmark of -36.9 per cent and the small industrials sector performance of -51.5 per cent.

However, Morningstar said the returns from ethical and non-ethical funds were broadly similar over long time periods, with mainstream funds performing slightly better for the most part. 

Its latest sector report cited a litany of issues with ethical funds, from a higher fee structure to concentration of funds managers and stocks, to lack of disclosure requirements. 

Although reports on performance, and most likely definitions, of what constitute responsible investments differ, some options clearly outperformed over the year. 

Money Management’s Fund Manager of the Year in the responsible investment category, Perpetual’s Ethical SRI Fund returned 39.36 per cent over the year to 31 May 2013. 

Lonsec said the manager had put “to bed the old chestnut that ethical investors forego performance for the feel-good factor”. 

EthInvest managing director Trevor Thomas said that as brand names such as Perpetual made their stamp on the responsible investing space, the real performance story may trickle down to the retail world. 

“With a good brand name and good performance, it’s easier and easier for planners to be able to do something in that space,” he said. 

“The empirical evidence just continues to mount that people don’t have to make a sacrifice.” 

Mainstream threads 

AMP, Hunter Hall, Investa, Perpetual, UCA Funds Management, Australian Ethical Investment and BT Financial Group are just a few of the 77 Australian signatories to the United Nations-supported Principles for Responsible Investment (PRI). The list includes 742 investment managers from around the world. 

Australia also contains 34 of the 266 asset owner signatories to the PRI including AustralianSuper, CareSuper, Cbus, CommInsure, First State Super, HOSTPLUS, Local Government Superannuation (LGS) Scheme, Media Super, Mirvac Group and VicSuper.    

“That’s been penetrating rapidly in the institutional end,” Harding-Davis said. 

“The majority of equity mandates in Australia have some cognisance of ESG criteria in their stock selection.” 

O’Connor agreed.  

“We’re now at the point where eight of the top 10 fund managers in Australia are PRI signatories and they manage over 50 per cent of total funds managed in this country,” he said.  

“You’re talking about a hugely mainstream movement at that end of things.” 

Signatories commit to incorporate ESG into their decision-making and their role as asset owners. The initiative’s stated purpose is to promote a more sustainable global system.  

Dalton Nicol Reid investment analyst Mark Sedawie said the PRI put pressure on signatories to engage with companies which in turn increased companies’ focus on ESG. A deeper level of engagement and research meant smaller companies were not overlooked through the ESG process as a result. 

“PRI really encourages you to engage with the company and in turn, we get the information that we want and it gets the companies to realise that there’s interest from investors,” he said. 

Harding-Davis said institutions’ concepts of share ownership had changed over time as growth in institutional assets had transformed them into major shareholders in the companies they invested into. 

“They were not natural owners, they were closer to speculators,” he said. 

However, larger investments come with larger responsibilities. 

Harding-Davis said asset owners had realised they were legally and morally responsible for the performance of the companies they held in portfolios. 

Mounting evidence that some companies were not adequately managing sustainability and ESG risks was driving the industry to invest responsibly to manage its own investment risks, according to O’Connor. 

“We just constantly see more and more examples of how this impacts on share price,” he said. 

“The list is becoming ever-longer of the News Corps, and the BP Limiteds and the Guns Limited and James Hardies – they’re just the big names.” 

Dalton said ethical considerations were particularly important due to the difficulty in pricing in ESG tail-risks. 

The risks involved in drilling activities in Sidoarjo, Indonesia, which caused a mudflow in 2006 which is expected to continue for 25 years, had been provisioned for $80 million on Santos’ balance sheet.

But according to Dalton that figure has changed dramatically, with some estimating it could cost the company $800 million – and Santos only had an 18 per cent stake in the operator. 

“That’s something that can really come back and bite you if you’re not really cautious about how companies approach their general activities and negative impact,” he said. 

“You can see that while legally the company may think it has quarantined some of that exposure, public outcry can really change that and that’s what’s happened with James Hardie – everyone’s avoiding their products.” 

James Hardie said last year that although the decision to compensate victims of asbestos-related illnesses would come at a cost to the company, it was unsure what the cost may be. 

The Rana Plaza collapse in Bangladesh which killed 1100 people is another case in point. On top of the human devastation, investment into companies which fail to adequately manage ESG risks not only proves destructive to a community but, ultimately, can be financially fruitless as well as damage brands. 

A growing number of retailers have started sourcing inputs from the least developed Asian countries, increasing labour and human rights risks – and reputational risks – for fund managers and the super funds that invest in them, according to Australian Council of Superannuation Investors.  

ACSI reports that Australian retailers increased inputs sourced from Bangladesh by 15-fold between 2006 and 2012. 

When examining the facts, the risks involved in investing with no regard for ESG are stark – something super funds are coming to grips with. 

According to SuperRatings, 97 per cent of super funds now believe corporate governance is the most important factor when investing responsibly – more than double the figures reported in 2009.  

Indeed, superannuation funds have had to increase their own governance standards under new Australian Prudential and Regulation Authority standards which require a pre-determined investment return and investment risks to be identified. 

Coupled with the mainstreaming of after-tax benchmarks, institutions are particularly concerned with the time horizons of the companies in which they invest, according to Harding-Davis. 

“It (after-tax) reduces turnover and changes your time horizon,” he said. 

“Once you change your time horizon, ESG factors start to make more sense. 

“Governance factors are unlikely to make a short-term difference in three-to-six months but over three years they will.” 

Ditching smoking guns and avoiding scandals 

With $62 billion in funds under management, AustralianSuper is a major asset owner and stakeholder in the companies it invests in. It seeks to influence the governance of the companies into which it invests through its Active Investor Program. 

The program operates on the premise that companies that have good ESG performance are more likely to increase value and maximise sustainable long-term returns for members, and an obligation on behalf of the super fund to make a concerted effort to manage all investment risks. 

Governance has become increasingly important to super funds as they attempt to manage the long-term outcomes of investments. 

An attempt to right the pre-GFC wrongs of short-termism has driven the global codification of transparency, which is also driving responsible investment among institutions, according to JP Morgan Worldwide Security Services head of global pensions, Benjie Fraser. 

“This transparency is around connecting the member to the trustees better, and then the trustee’s responsibility as an asset owner towards the companies it invests in,” he said. 

Fraser said lobbying by UK pension funds in relation to disclosure of directors’ remuneration and to split the roles of chairman and chief executive were just one example of how transparency was impacting on governance. 

Further ESG developments could be seen in a movement to ban pension fund directors in the Netherlands from holding seats on the boards of cluster mine manufacturers; and the divestment by a cohort of Californian Pension Funds of shares in companies that manufacture guns and armaments used in the Sandy Hook Elementary School massacre. 

“CalSTRS’ action targets ammunition clips that turn ordinary guns into killing machines, assault weapons and other firearms that post extreme dangers to public health and safety,” Californian Treasurer Bill Lockyer said at the time. 

The divestment of stocks is often the most public face of institutions’ responsible investment practices, and can be linked to transparency and public pressure. 

The Future Fund in Australia, under public scrutiny and lobbying by responsible investment organisations, divested itself of tobacco manufacturer stocks early this year. 

As the Federal Government continues its crack-down on tobacco in an effort to reduce future health costs, the divestment of tobacco manufacturer stocks by super funds in Australia has received steady attention.

VicSuper. HESTA, SAS Trustee Corporation and Sunsuper all ditched stocks over the past year. 

However, super funds’ increased use of responsible investment practices has not just been reactionary.   

The failure of Socially Responsible Investment (SRI) options to attract significant member interest meant super funds had limited scope to influence business behaviour. 

Over the last three years, 20 per cent of super funds have shifted from a standalone SRI option to implement a whole-of-fund ESG approach, according to Super Ratings. 

An ESG overlay can screen out companies with significant ESG exposures across a fund’s portfolio. 

LGS Super chief executive Peter Lambert said the ESG overlay it employed Hermes to perform over its international equities portfolio was quite simple. It included a number of risk controls that might conflict with the fund’s “true believers” and which were better suited to its SRI option. 

“Whilst the overlay concept is good, the reality is it would be far better to have managers invest directly into the stocks you like in the first place, rather than pull out and replace stocks,” he said. 

Australian Ethical general manager – distribution Adam Kirk also said that ESG overlays lacked depth as they rarely contained negative or positive screening and had too much of a focus on governance. 

However, O’Connor said the extension of asset classes within which ESG factors were being considered was deepening the market for responsible investment.   

“What we’re seeing is a bigger interest in spreading responsible investment into other asset classes beyond just listed equities,” O’Connor said. 

These included infrastructure, climate bonds and other social impact bonds, and renewable energy assets. 

“Asset owners are getting so big and just swamping the ASX – let alone what the future will look like in the late 2020s when there is $7 trillion under management,” O’Connor said. 

“There is a desire for new asset classes that meet the risk profile of institutions.” 

Social benefit bonds, the latest responsible investment vehicle to hit the institutional world, offer returns backed by the Government on the achievement of pre-determined social goals. 

O’Connor said they were receiving a lot of interest. The popularity of such an investment vehicle can be seen in the early closure of the UnitingBurnside social benefit bond, which NGS Super awarded a half-million dollar mandate. 

Commonwealth Bank and Westpac Institutional Bank also released a social benefit bond through The Benevolent Society. 

Bringing it back to the dinner table 

Asset allocation and timeframes of superannuation investments and rollovers are, as a dinner party conversation opener, likely to leave a dinner guest lonely on subsequent Saturday nights.

But inject a bit of flavour into the conversation and a guest could be remembered as engaging and invited to dinner again – an experience the financial planner could take a cue from, according to senior manager of responsible investments at Bendigo Bank, Justin Medcalf. 

He said planners needed to dig deeper and engage clients on their ESG concerns. 

“If I brought up issues around coal seam gas and how to transition to a future economy and what that means for future generations, it’s going to be a more engaging discussion,” he said. 

Most people had ethical considerations but did not “connect the dots”, according to Medcalf. 

“I don’t think there are too many people in the room that would say tobacco’s a good thing, and most of us are pretty aware of the social implications of gambling when it’s on the extreme.” 

Dalton agreed: “If you do take the conversation to ‘are you interested in investing in a responsible manner?’ it’s hard to find anyone that says no,” he said. 

Research by the Australian Institute seems to support this notion. 

It said the low take-up of SRI options within superannuation was not surprising, given that MySuper legislation acknowledged such a low level of member engagement. 

Research released in March found that 40 per cent of super fund members believed ethical and environmental implications of super funds investments were in funds’ long-term interests. Just over one third (36 per cent) said simply maximising financial gains was of importance, while 23 per cent were not sure. 

Although the results varied by gender, age and income differences, on average, as ages rose the percentage of those who were unsure shrunk in favour of those who supported an ethical and social thrust in their super fund’s investment philosophy. 

Respondents also seemed to be likely to switch funds based on ESG factors if they were made aware of them.  

A quarter of respondents said they would move their superannuation to another fund due to the environmental consequences of coal or coal seam gas extraction, while 43 per cent said they would not.   

Ask about tobacco or land mines and the proportion of people would more than likely be much higher, according to the Australia Institute, so 25 per cent could be considered a minimum. 

So, the real challenge in the responsible investing space, according to the Australia Institute, is one of engagement. 

Kirk said advisers had often steered conversations away from responsible investing. 

“I think that a lot of planners actually ignore it completely because there’s that myth that responsible investments underperform mainstream investments,” he said.   

Dalton said research had shown most people did care about ethical issues. 

“Everybody’s interested, but I think there’s a reluctance to pick responsible investment options because of this perception of performance,” he said. 

“I think education at the adviser level comes back to the fact that you don’t forsake performance,” Dalton said. 

Conversations, however, have started to change as advisers realise ethical investment considerations can not be addressed with one simple question, according to Kirk. 

“People are becoming aware that it’s more in-depth than that,” he said.  

“Planners need to understand more about their clients, and that could be part of the ‘get to know you process’ with the client – that they really understand their values and where they want to be.” 

O’Connor pointed out that short-term performance horizons did not align with the long-term investment horizons of responsible investments. 

“Some of that misalignment between our time frames – and some of the incentives around short-term performance – really don’t assist in illustrating that ultimately if a company is governed better, treats its staff better and doesn’t pollute in its backyard, generally it’s going to be around for the long haul,” he said. 

Thomas said that although there might be a mismatch between planners’ and clients’ considerations based on planners not being attuned to ESG issues, a bigger problem was planners’ lack of access to responsible investment options on approved product lists (APL). 

“They want to know their client and understand what their client wants, but they have one hand tied behind their back in terms of what they can recommend,” Thomas said. 

EthInvest received many referrals and clients who were unhappy with an adviser’s service. 

“We’ve always had a steady trickle of people that have said ‘I’m sick of being patronised, I’m glad to see someone who thinks I’m rational’,” he said. 

Thomas said planners should pressure their dealer groups to include responsible investment options on APLs.