Wading through the ESG noise

When it comes to responsible investing, it is easy to be bombarded by the numerous acronyms and confused by the different definitions and terminology. 

Environmental, social and governance (ESG), responsible investing (RI), sustainable investing and impact investing are everywhere these days, and rightly so. But the array of options can be confusing for the financial adviser looking at a product and trying to work out which best suits their client’s needs.

There is a lack of a common language or common definitions around many of these terms. While some professional bodies are looking to introduce standard definitions – the CFA Institute has recently come out and set global standards on how funds consider ESG issues in their objectives and processes that we hope become widely embraced – advisers need support when it comes to explaining responsible investing to their clients.

THE RIGHT DEFINITIONS

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It is helpful to start off by looking at RI investing by breaking it down into three key approaches. At one end of the spectrum there is the values-based approach, or the ethical investment approach, that’s been around for decades, which avoids companies and industries where you don’t want your money to be invested.

At the other end of the spectrum, there is sustainability and impact investing, where people invest their money to advance certain criteria, or to have a positive impact. And in the middle is the concept of ESG integration, which looks at risks and opportunities through ‘E’, ‘S’ and ‘G’ lenses but can also overlap with both ethical and sustainable approaches.

The biggest issue with terms like RI, sustainability and ESG, is that much of the market uses them interchangeably. But they are not substitutes for each other, and should not be used in that way.

For example, an ESG-driven approach isn’t necessarily about ‘sustainability’. When it comes to sustainability, we believe the investment has to be pursuing and actively articulating quite a narrow set of themes contributing to sustainable solutions. If it encompasses impact investing, it has to be able to define the difference the investment is going to be making. 

But if it is just a matter of looking at your investment universe through the lens of ‘E’, ‘S’ and ‘G’, that’s a different thing altogether given that, in and of itself, ESG incorporation is not about applying a moral judgement.

TOOLS TO WORK WITH

If it is hard for the industry to agree on definitions for the different kinds of responsible investing, then it will obviously be confusing for the end investor and the financial adviser advising them. We have spent a considerable amount of time assessing how best to help advisers with this problem after deciding to more formally address this need in 2019.

It is important to provide tools that can assist advisers in deciphering the RI credentials of any product they are looking at and, as such, in 2021 we finished rolling out our RI classifications across Zenith’s Approved Product List (APL), which now totals more than 950 funds. 

We decided to start by putting together a series of classifications that simply distil and describe how much ESG is incorporated into a particular fund by its fund manager during the investment process. Is it a lot, a little, or none at all? We feel the benefit of this approach is that it can be applied to any asset class, investment style or implementation method – equity or credit, value or growth, index or active. It is a means of creating a level playing field on every fund that we cover.

It is important to recognise that the classifications are a tool to identify ESG incorporation rather than an assessment of ‘greenness’ or ‘goodness’. As such, Zenith’s five RI categories are detailed below: 

• Traditional – seeks to achieve a stated investment outcome, with little to no regard for RI/ESG factors;
• Aware – seeks to achieve a stated investment outcome, taking into consideration a broad range of factors including RI/ESG;
• Integrated – seeks to achieve a stated investment outcome, expressly taking into consideration RI/ESG factors which materially alter the fund’s permitted investment universe and portfolio allocations;
• Thematic – seeks to achieve an investment outcome that includes an explicit RI/ESG objective that is both measurable and reportable; and
• Impact – targets investments aimed at generating a positive, measurable social and environmental impact alongside a financial return.

Chart 1 displays the RI categorisation of our APL across different asset classes.

Chart 1: RI categorisation across asset classes 

It is important to note that the Thematic and Impact categories highlight funds that are extending their approach and objectives beyond the Integrated classification. Funds in these categories are required to display a robust assessment of both RI issues and formal engagement along with suitable objectives and processes.

Thematic products invest specifically in themes or assets related to sustainability such as renewable energy, sustainable agriculture or affordable housing. Impact products, however, must be designed to generate a positive, measurable impact in addition to a financial return with full transparency and enhanced engagement activities.

Among Zenith-rated funds, listed property and infrastructure as well as unlisted real assets have the largest proportion classed as ‘Integrated’, meaning they expressly take into consideration RI and ESG factors during the investment process. 

We see this is logical as operators in the built environment have long considered issues around energy, air and water as being accretive to their bottom lines. In addition, their role in generating carbon emissions has only further propelled these industries into the forefront of addressing sustainability challenges. While Australian and international shares funds also have a large number of funds incorporating RI and ESG factors, just over half of the universe have incorporated ESG comprehensively.

For advisers seeking to consider ESG or RI as part of their product selection, these classifications will help them understand whether or not a fund manager is thinking deeply about those issues at a product level. If they want to include products that are run by managers truly embracing responsible investing, then tilting the product selection towards those that are ‘Integrated’ can provide benefits in achieving fund objectives.

However, if advisers want to use managers that are going further and trying to initiate change in an industry or a sector, they can also include funds that have Impact or Thematic classifications. 

However, labels aren’t everything, and it is important to consider responsible investing on a principals-led basis. Is an approach fit for purpose? It doesn’t make sense to look at an index fund the same way an adviser would look at an active manager that is trying to run an impact strategy, for example, but both types of funds can have a role in a portfolio even if they have quite different RI classifications.

‘Greenwashing’, or products being intentionally mislabelled as pursuing RI principles, is an ongoing issue, as is ‘greenwishing’ where funds might genuinely seek to be pursuing positive goals, but are conflating ambition with reality. 

However, it is also important to be wary of the source of ‘greenwashing’ allegations. One of the challenges of RI is that it is judgement based and the field of view depends on where you stand. While one adviser or investor might consider a fossil fuel company quite ‘green’ if they are actively transitioning towards sustainable energy, another might just draw a line through all fossil fuel companies as being ‘brown’. An adviser needs to understand what a fund’s objectives and definitions are first before they can make a judgement call.

SUPERANNUATION

We have also adopted the same RI classification approach to superannuation funds. Our superannuation research and consultancy business, Chant West, has incorporated this framework into its ratings for multi-manager options. 

The classifications also work to assist fund members and their advisers to understand the integration of a superannuation fund’s RI themes into their processes and the associated impacts on the final portfolio outcome. 

Just as advisers use these classifications to assist end investors, members of superannuation funds can use them to understand their particular fund’s investment option’s approach to RI investing. 

While we understand that fund managers and super funds need to be able to measure and demonstrate the role of RI in their investment strategies, we believe it is equally important that investors can accurately identify which superannuation strategies meet their needs and align with their investment beliefs.

This is particularly important in the superannuation space where investors have long-term retirement goals and need to align both their investment goals and RI preferences with their long-term objectives. 

THE PROCESS

Increasingly, responsible investing is becoming more of a critical part of any fund manager’s risk process. Fund managers not thinking deeply about how they incorporate ESG into their investment process may need to question whether or not they are fulfilling their fiduciary duty.

At Zenith, we do not have a separate team responsible for examining RI. While we have an internal Responsible Investment Committee that oversees our processes in this space, we also think it is very important that every research analyst takes a hands-on role in considering RI when they review and assess funds and their management. 

By not isolating our RI process in a separate team away from the rest of our analysts, we can avoid siloing ESG in a way that may be potentially unhelpful. We believe it should be at the forefront of every analyst’s mind, in the same way that factors such as processes, fees and performance are considered. 

The Responsible Investment Committee exists to support all our analysts and to keep them up to date with new initiatives, new thoughts and new views, and continue upskill them on developments in responsible investing.  

The committee is also drawn from all aspects of our business - from our research team, our portfolio consulting team, our legal and compliance team and our data team. This diversity of thought and views is important in order to be able to come up with the most effective set of solutions possible, as we are also about to launch additional tools to help advisers in this space. 

Ultimately, the RI classifications provide advisers with an additional tool to differentiate between funds, and identify those best suited to clients seeking to add ESG sensitivity to their portfolios. But like all tools, it works best in conjunction, not in isolation.

Dugald Higgins is head of responsible investment at Zenith.