Responsible investments: Separating the wood from the trees

Responsible investments have become increasingly popular over the last 10 years with investors choosing to divest from unsustainable, unethical companies and the evidence suggests this is owed in significant measure to a generational shift.

EthInvest financial planner, Trevor Thomas, said the driving force behind the sudden spike in responsible investments can be put down to a generational shift in wealth, with millennials engaging with investment decisions and divesting from things like fossil fuels, armaments and tobacco producers. 

Executive director of Pengana Capital Group, Adam Myers, agreed, adding that the trend is consistent with increasing awareness.

“If you ask the managers why they are allocating more money to responsible investment strategies, the answer is invariably ‘because it is aligned to my ethics and morals’, and I think that’s a significant change,” he said. 

The trend reflects both a spike in demand from clients to be more responsible in their investing, and a greater supply of investment opportunity, according to chief investment officer at Crestone, Scott Haslem. 

“Because we have a lot more ability to assess the ESG status of companies, we are seeing a lot more funds not only in equities but also in fixed income and credit, where you’re getting access to more investment options that have this ESG overlay.”

Responsible investments and how to find them

Although responsible investments are loosely defined, experts in the industry point to investments that have an environmental, social or governance (ESG) focus.

This means investing in companies that look to, on a base level, act sustainably and ethically. 

Funds that label themselves as “responsible” employ screens that aid fund managers in deciding what to divest from, with most funds choosing negative screens to block out companies that are not deemed ethical or sustainable. 

“That’s generally the gambling/tobacco/pornography/arms side of it,” said Thomas. “Often, though, the best companies utilise a positive screen, and proactively look for positive investments that are making the world more sustainable for the future.”

The negative, exclusionary approach is straightforward, transparent and ensures investment alignment with ethical beliefs.

It does, however raise the question as to whether investors should penalise a company for producing products demanded by customers. 

A related concern is that by withholding capital from a legal and well-managed business, you could direct it towards entities with fewer controls and less subject to shareholder scrutiny. It also reduces the available investment universe, which could curtail performance and increase risk. 

This then supports Thomas’ assessments that perhaps companies could better employ positive screens that don’t necessary block anything out, but rather actively seek sustainable companies. 

David Bassanese, portfolio manager of BetaShares’ ethical fund, said as well as positive and negative screens, there are narrow and wide screens.

Given there’s no generally agreed upon definition of what it means to be a responsible investment, funds often choose to employ narrow screens. 

“There’s some funds that have been dubbed ‘ethical funds’, but because of their narrow screens, they don’t actually exclude any stock holdings in the ASX 200,” he said. “We’ve taken this on board, and tried to adopt the widest range of screens that concern investors, and be as rules-based and objective as possible.”

Bassanese said BetaShares Ethical fund includes fossil fuel producers, while others would exclude producers but include coal-fired energy plants. 

“Our screens exclude these sorts of companies, and we employ the typical negative screens that concern investors such as armaments, gambling, tobacco and alcohol,” he said.

“We also insist on those companies being leaders in the industry in the sense that their carbon footprint has to be below the industry average, so below 60 per cent.”

Myers warned however that funds can fall into a trap of making responsible investing a “box-checking exercise”.

“We have to differentiate between a box-checking exercise, and a manager that’s really separating the wood from the trees,” he said. 

While a bank may deem itself as having a small carbon-footprint, this doesn’t necessarily mean it’s a responsible investment. 

“We’re not concerned about their environmental impact, but we are concerned with their fair marketing, advertising and treatment of employees – it’s a different subset of facts.”

“You can get consultants who nominate ‘the 40 important factors’, and if the company fulfils all 40 they get an A plus. If they only do 20 of the 40 they only get 50 per cent, but the 20 that they do may be the critical ones.”

Bassanese advised investors to “look under the hood” to see exactly what the fund is invested in and what it excludes to really determine whether it’s a responsible investment. 

Should you prioritise E, S or G?

ESG is described as a lens through which investors view funds, and while the environmental facet of ESG-investing is often sensationalised, companies that have a strong governance focus have tended to produce bigger returns.  

“People have tried to effectively rate companies on their E, S and G qualities, and in order to do that, they have created these metrics and score cards,” said Lumenary Investment Management portfolio manager and founder, Lawrence Lam.  

Lam said while there are some definitive metrics, like measuring carbon footprints, the metrics for the governance of a company are a little less black and white, and there’s a lot of work to be done. 

He said investors generally thought of the ‘E’ component of ESG, because it’s a tangible metric, but from a returns perspective, the studies have shown that good governance produces better returns. 

“The governance structure of the business often drives the ‘E’ and the ‘S’,” he said. “If the G is right, the company will think long-term, they will think about sustainable practices, and the ‘E’ and ‘S’ will naturally fall in place.”

Haslem agreed, noting that Crestone clients have tended to have a strong interest in environmental issues and governance policies as opposed to social issues. 

“What we’ve seen over the last year or two is a number of examples of companies, such as Volkswagen, that would have been excluded from a negative screening perspective had they been invested under an ESG framework,” he said. 

Myth-busting

Interest in sustainable investing is hindered by an enduring belief that such investing involves a financial trade-off, with planners and fund managers alike attesting to this attitude from clients. 

Haslem said while the perception existed, there was a large number of recent studies highlighting that an ESG framework doesn’t have to come at the expense of returns, and, in some cases, it may actually enhance them. 

He said this reflected that the companies who were striving for ESG excellence, also had a natural drive to more innovative behaviour, were more efficient, had better leadership diversity, and this often aligned with stronger financial performance.

“I do think of the funds that we at Crestone are putting to our high and ultra-high net worth clients, we’re seeing a lot more of ESG fund opportunities that are not underperforming the market.”

Haslem said one of the reasons for this is that ESG is growing past equities to fixed income and credit, as a means to provide appropriately diversified portfolios, but not at the expense of return. 

“I think that’s a key point, that the growth of ESG beyond equities into fixed income and credit is providing financial advisers and clients the opportunity to build portfolios that are appropriately diversified and under a responsible framework.”

A Morgan Stanley survey conducted in late 2017 found that 53 per cent of investors believed that investing sustainably required a financial trade-off, with millennials more sceptical than the general pool. 

“There is a misconception that investing responsibly is associated with inferior investment returns,” agreed Myers. “That just isn’t accurate."

According to FE Analytics, this rings true. Since Pengana Capital took over the Hunter Hall International funds in March last year, and partnered with WHEB Asset Management to form the Pengana WHEB Sustainable Impact Fund, it was the second-best performing ethical fund, producing returns of 7.96 per cent. 

Responsible Investments Australia also released a Benchmark Report last year that proved responsible investment Australian share funds outperformed the average large cap Australian share funds over three, five and 10-year time horizons. 

In terms of fees, Thomas said the premium for ethical screening used to be higher but has been competed down, and is now seen as part of general risk management. 

“Now, more than half of managed funds in Australia apply some sort of ESG risk because they understand it will contribute to financial performance,” he said. “Arguably, you pay a bit more but you get a lot more.”

So, while there are premiums to ethical screens, Thomas said high fees were something of a myth these days, mainly perpetuated by “self-serving financial planners”.

“There are over 15,000 planners in Australia who are telling their clients who want to invest ethically that it’s irresponsible, that you won’t get as good returns, that you’ll pay a higher fee and it’s based on the fact that they can’t actually offer the products - not the truth.”

Is passive investing compatible with responsible investments?

Responsible investing, from the outset, requires an active decision by an investor to invest in responsible companies with an ESG focus. 

The current structural shift in asset management towards more passive investment approaches could therefore be viewed as incompatible with the active engagement required to invest responsibly. 

Active managers can choose to sell companies they deem irresponsible, and are also incentivised to attend annual general meetings (AGMs) and vote to change companies to become more responsible by the returns they stand to make.

Passive investors, however, are not in a position to sell companies, and are generally not incentivised to attend AGMs as they’ve opted for low cost, and chose to make the returns the index makes.

The challenge therefore exists for passive managers to combine active engagement with lower fees. 

The European passive market is waking up to possibilities for tilting benchmarks, so they have excluded “irresponsible” companies from an ESG perspective, and invented ESG-themed indices, like the FTSE4Good. 

Haslem said Crestone tended to have a preference towards active managers who had a strong history of outperforming benchmarks, but that ETFs provided investors with the opportunity to access themes across countries and sectors with a broad exposure.

“Now that might be European financials, or US mid-caps, but we’re also seeing a broad range of ETFs that provide access to sustainable investments,” he said. 

The issue there, he said, was that advisers needed to think carefully about what lens they’re viewing ESG through, and whether it was a theme to form part of a portfolio, or a philosophy that dominated all of their investments.

Gatekeepers and stewardship

While responsible investment has emerged as a powerful trend that is proving to be more than a phase, it’s resilience and growth is being tested by a failure on the behalf of advisers, or “the gatekeepers”, to offer and promote such investment opportunities, according to Thomas.  

“Planners try to talk clients out of investing ethically, and they do that because they work for large financial institutions who don’t have very many ethical investment options on their menus,” he said. 

“There needs to be greater emphasis by the large institutions that employ those people to include responsibility as a key driver in understanding client needs. All financial planning starts with this concept of ‘know your client’, and it should be that you take their values seriously as well as their financial needs.”

Thomas said this was due to the higher costs of ethical screening and the lack of options on approved product lists. 

While Haslem couldn’t comment on other planners’ product lists, he said Crestone was increasing opportunities. 

“Certainly at Crestone, we are increasing the opportunities that we offer to our clients, and particularly across not only the traditional equity-style investments, but also ETFs as well as fixed income funds that invest from a responsible perspective,” he said. 

Responsible stewardship is also needed to grow responsible investments, and a focus on a more active ownership where shareholders looked to promote value creation that could be sustained is what the industry needs to continue.

Financial adviser at Quantum Financial, Claire Mackay, said the industry is seeing shareholders and key stakeholders taking a stand against legal and ethical failings now more than ever. 

“I think we’re seeing examples of shareholders becoming far more active in this area right now with institutions such as AMP,” she said. “This type of public example of holding people accountable for their actions is a great way to encourage more responsible investing.”

When investors are pressured to fulfil their stewardship responsibilities, there will also be a concurrent focus on corporate governance, or the system of checks and balances within companies to ensure executives are aligned with long-term shareholders’ interests. 

Does it have to be all-or-nothing?

Investors often think that responsible investing is an all-or-nothing exercise, but planners and fund managers alike say there’s room for both. 

Bassanese said while ethical considerations are a positive movement, he wouldn’t preach to investors to head down the ethical path. 

“We have funds that don’t have those ethical screens,” he said. “But, if you are ethically minded, there are a lot of negatively-screened funds out there to invest in.” 

He said while BHP, for example, was a fossil fuel producer, it was also a well-run company that observed good corporate standards. 

“For our criteria, it wouldn’t be included, but all these companies are engaged in legal activities and there is a place for them,” he said. 

Haslem said constructing a client’s portfolio to meet their individual return and risk profile was paramount.

“Not all of our clients share the belief structures, or have the same motivation to align their political or social beliefs with their investing,” he said. “It’s a very individual environment, and we meet the needs of our clients.”

The key point, he said, was that investing responsibly was no longer viewed as an “all or nothing” space, and in many cases, clients are aiming to make their portfolios progressively more responsible. 

“That doesn’t necessarily have to involve a wholesale leak, it can involve just looking at that portfolio, assessing where the least ESG parts of it are, and over time, with an eye on diversification and risk, starting to progressively move that portfolio on to a more responsible footing.”

Haslem said the message needed to be communicated that it isn’t that complicated to create a well-diversified, globally-diversified portfolio within a responsible investing framework.

Responsible Investments Snapshot

FE Analytics has filtered the ethical funds in the Australian Core Strategies Universe, which is designed to remove all the master trusts and sibling funds to help investors’ navigate the core fund strategies, by searching their product disclosure statements (PDSs) and flagging them as ethical or sustainable. 

Top three performers comparted to the sector and the index

Source: FE Data

The data showed Colonial First State’s (CFS) Generation WS Global Share was the best performer over five years, returning 19.87 per cent. 

The fund was awarded a FE five-Crown rating, and has outperformed the Global Equities sector, which returned 12.84 per cent, and the MSCI World (ex Australia) Index, which returned 15.83 per cent, over a five-year period. 

The three-Crown rated CFS Wholesale Worldwide Sustainability fund placed second, with total returns of 13.70 per cent over five years, more than the Global Equities sector, but just under the MSCI All Country World Index returns of 14.80 per cent. 

Some familiar names could be seen on the list, with Australian Ethical’s Australian Shares, International Shares, Diversified Shares and Advocacy funds placing within the top ten performers. 

Pengana’s International Ethical Opportunity and International Ethical funds place eighth and ninth at 11.16 and 10.95 per cent respectively. 

Performance of the top ten ethical funds in the Australian Core Strategies Universe over five years

Fund	5 year Cumulative Performance to Last Month End Annualised
CFS Generation WS Global Share ATR in AU	19.87
CFS Wholesale Worldwide Sustainability ATR in AU	13.7
AMP Responsible Investment Leaders International Share ATR in AU	12.97
Ausbil Candriam Sustainable Global Equity ATR in AU	12.85
Australian Ethical Australian Shares ATR in AU	12.75
Australian Ethical International Shares ATR in AU	12.67
Pengana International Ethical Opportunity ATR in AU	11.16
Pengana International Ethical ATR in AU	10.95
Australian Ethical Diversified Shares ATR in AU	10.57
Australian Ethical Advocacy ATR in AU	10.38

Source: FE Analytics

Of the top ten performers, only CFS’ Generation WS Global Share fund is outperforming the Index, but the Index is not specific to ethical funds, which makes performance comparisons difficult.

After looking at the individual funds’ asset allocation though, it becomes clear that, despite branding themselves as “ethical”, the ethical screens employed by the funds can be quite narrow, and every fund has a different definition as to what “ethical” really is. 

For example, AMP’s Responsible Investment Leaders International Share Fund was the third-best performer, returning 12.97 per cent across a five-year period, compared to the Global Equities sector and the MSCI AC World index returns of 14.80 per cent. 

The fund’s top ten holdings included Pepsico Inc, Apple Inc, Microsoft Corp and Statoil ASA. 

Statoil ASA, which is undergoing a rebrand to become Equinor, is a Norwegian energy company, that despite committing to cutting greenhouse gas emissions since the Paris agreement, is still hesitant to give up on fossil fuels completely.