Ethical Investment: Performing responsibly

Long-held skepticism about the performance of ethical funds appears to be unfounded. Why then, are the funds still slow to gain traction, asks Nicholas O’Donoghue.

Questions over the performance of responsible investment funds may be a thing of the past, with the environmental, social and corporate governance (ESG) focused funds matching if not surpassing traditional investment models, according to research.

While investing in ESG funds can give investors the warm and fuzzy feeling of supporting businesses that do not harm people or the environment, the rigorous criteria fund managers assess before buying into companies reduces the risk associated with these investments, Responsible Investment Association of Australasia (RIAA) chief executive, Simon O’Connor believes.

“The importance of the non-financial [issues] is up there with the importance of the financial, because what we see consistently are textbook examples of companies either destroying shareholder value, or enhancing shareholder value by mismanaging so-called non-financial issues,” he said. 

“We see that when people fail to manage corruption for example, or fail to deal with communities properly – to get that social licence to operate – all of a sudden, those non-financial issues can rapidly turn into financial risks and material risk factors for a company.

“They have the ability to stop projects from going ahead, raise the cost of a particular project, push out timelines, or end up with regulatory pushback, all kinds of implications that are very much financially material.”

Performance on par?

Despite perceptions that socially-responsible investing (SRI) fails to match more traditional funds, data from the RIAA’s 2013 Responsible Investment Benchmark Report, showed ESG-focused funds outperformed the average of the ASX (Australian Stock Exchange) 300.

The RIAA chief said that the 2013 report was no one-off for responsible investment funds, with ESG showing comparable results to mainstream investments every year since the association’s first benchmarking report in 2002.

“Every year we do a study of that… we see really strong and in fact stronger performance from responsible investment funds over Aussie equities, international equities over the short-term and the longer-term,” O’Connor said.

“What’s very pleasing is performance seems to be comparable, if not better, in terms of the industry data that we highlighted a year ago when we saw the results coming out from the major super funds and fund managers were a number of responsible investment funds were in the top of the league charts in terms of performance.”

AMP Capital Head of Environmental, Social and Governance Research Ian Woods also backed SRIs to perform well when compared to traditional investments.

“It’s really a myth that some people have that somehow these funds underperform,” he said.

“There is good reason why you’d expect these funds to perform as well if not better than other funds... if you think of some of the things that have occurred in terms of climate change, concerns over supply chain issues with garments coming out of Bangladesh, issues around governance in the Global Financial Crisis it’s not surprising that funds that specifically look at these ESG issues pick up on risks and opportunities that other funds might not see and therefore can perform from a pure financial perspective as well if not better than traditional funds.”

Deep insight

For many working in the SRI space it’s no surprise that the funds perform well.

“You get a deeper insight into the companies, because you’re looking under the bonnet, about how these companies are managing customer service or safety or environmental performance,” Woods said.

“You’re looking more specifically at the remuneration of senior executives, seeing what’s driving performance. 

“If you look at the value of companies on the ASX200 about 75 per cent of their value is made up of intangible assets – a lot of that has to do with relationships with customers, suppliers, regulatory authorities, employees, etc… so you literally research that. 

“You look at how well those companies are managing those relationships so it’s not surprising if you start looking at those things you’re looking at where companies derive value.”

For AllianceBernstein chief investments officer – Australia value equities – Roy Maslen, ESG research should not be seen as a “bolt-on” when it comes to investment strategy.

“We believe ESG research is an important part of an investment process and that investors should expect their managers to look as a matter of routine at the risks and opportunities that arise from ESG factors,” he said.

“So advisers, in our view, should expect their core investment managers to be rigorous about doing ESG research.

“Our view is that [ESG factors] should not be considered as a bolt-on or an optional extra.”

Cost of funds

Given the active nature of SRI funds, AMP’s Woods said investors who choose ESG options will pay higher management fees than some traditional funds that require less research and monitoring, but stressed the fees reflected the research managers did to assess the businesses they invested in.

“The fees are comparable to other active funds that are readily available to retail investors,” he said.

“They also provide an advantage to the client of engaging with the companies – it’s not all about investment return, it’s about being representative of the owners of the company to engage with them on ESG issues.”

Australian values

From an investment point-of-view, RAII’s O’Connor believes that idea of responsible investment enables Australians to support businesses that reflect their values.

“People tend to be attracted to this area because most Australians’ values come into all the decisions they make in their daily life, so it’s not surprising that some sense of values or ethics come into play when they’re wondering where they’re going to invest their life-savings,” he said.

O’Connor’s view has been supported by the results of an RIAA survey, which found the majority of participants said they would prefer their super to be invested in an ESG-focused fund rather than one that was solely focused on maximising financial returns.  

“What we found was that the vast majority [of respondents] expected as a minimum that their super fund does no harm,” he said.

“People are now cottoning on to the fact that you can invest responsibly and maximise financial returns.

“This demonstrates the enormous potential for growth in the responsible investment sector. Even more significant is that seven in 10 Australians think it’s important for super funds to make responsible investments… by investing in companies that build clean energy infrastructure of avoid investments that harm the community like tobacco.”

Woods also noted that Australian investors have been taking a more proactive approach to their super funds, wanting to ensure their money is being invested in companies and projects that match their personal values.

Environmental disasters such as BP’s Deepwater Horizon oil spill in 2010, and social issues like the Rana Plaza collapse in Bangladesh last year, which claimed the lives of more than 1100, factory workers, have prompted investors to become more mindful of where their super was being invested, he said.

“People feel quite strongly about these types of things,” Woods said.

“Clearly climate change is a big issue for many, human rights and supply-chain issues are also concerns.”

Proactive approach

With many Australians expressing concerns about their investments, Woods believes that fund managers can have a crucial role in pushing for change within the businesses they have invested in.

“People want to be active owners and see that the people who are managing their money are engaging with companies and their boards on the key issues,” he said.

O’Connor believes that fund managers who act as the voice of their investors by engaging with companies and encouraging them to pursue ESG-friendly goals, can reap positive outcomes for everyone

“We’re seeing an increasing number of investors engaging directly with companies to work with them and help them to manage those non-financial risks, to help them to identify and work through ESG risks,” he said.

“That’s starting to spark a really interesting conversation, where hopefully the outcome is better for companies and investors.”

Growth forecast

While the RAII research has found that many Australians support the concepts of ESG, and have stated that they want their super invested in business that reflect their values, O’Connor said demand for ethical products had remained relatively low.

“Despite a really strong emerging movement of a more conscientious consumer we haven’t really seen that translate into the scale [of investment] that we would expect into responsible ethical sustainable financial options,” he said.

“[However], we’re of a view that we will start to see that translated into bigger retail demand in the coming years as we see Australians becoming more conscientious with their consumption decisions.

“We’re seeing the early moves on that now and I guess that’s best highlighted by the emergence in the last 12 months of civil society campaigns that are harnessing Australians to get in touch with their super funds on various issues.

“Across our membership we’ve seen a really strong emergence of email campaigns from non-governmental organisations (NGOs) and civil society groups around a whole raft of issues from tobacco through to fossil fuel divestment and even issues such as transfield services taking on the contractor managing the Manus Island detention centre.

“This is really healthy and a good step that people are actually more actively starting to choose where they’re investing and starting to ask their super funds about the types of companies and industries they’re investing in.”

Exclusion

A number of funds announced divestments from various sectors, with both Hunter Hall and AMP’s RILs fund setting limits on companies’ exposure to fossil fuels in May this year.

Hunter Hall chief executive officer, David Deverall, said the group had a materiality limit of 10 per cent on the production of fossil fuels, but would assess companies on an individual case basis. 

Australian companies including Woodside Petroleum, Santos, Caltex, and global companies such as Peabody, Chevron, BP, Exxon Mobil have all been placed on Hunter Hall’s exclusion list, based on ESG requirements.

Founder and chief investment officer Peter Hall said the firm had always been underweight in the fossil fuel sector.

“But the decision to end fossil fuel investments outright enables Hunter Hall to focus on a future with new opportunities,” he said.

Woods said that companies that had a more than 20 per cent exposure to fossil fuels including, mining thermal coal, brown-coal or lignite coal-fired power generation or exploration and development of oil sands, were excluded from AMP’s RIL funds.

“Our clients expect us to invest their funds in a manner that suits their social conscience while at the same time meeting investment objectives,” he said.  “This move enhances our ability to do that.”

Woods said that while the decision to exclude companies with high exposure to fossil fuels was a worthy of note, he said it was a natural progression under the RIL funds’ charter.

“It isn’t something that came out of the blue,” he said. “Because of our charter, especially the ESG tilt, we found that we didn’t have a very high exposure to those fossil fuel companies that we’ve now excluded… it’s an obvious evolution of the fund.”

Carbon tax repeal

While the Carbon Tax is set to be repealed, Woods believes the move could spark increased interest in SRI funds.

“My guess is that it will increase the interest in these types of funds,” he said.

“I think those who saw the Emissions Trading Scheme and the Carbon Tax as a positive way for Australia to address climate change would be disappointed that the Carbon Tax is proposed to be repealed.

“But those asking ‘what else can I do personally to deal with the issue of climate change’ will be looking at investments that look to address that, and I hope that will increase interest in these sorts of funds.”

Green options

With consumers becoming increasingly conscious of their investment options and SRI funds, RAII’s O’Connor said there were now a number of options with themed funds and “green bonds”.

“We’re seeing products being specifically tailored [with an ESG focus], not just in the equities space, but in the fixed-interest space as well,” he said.

“We recently saw a very large bond issuance form the World Bank launched in Australia where Uni Super took the major stake… the funds that are raised through that bond will be directed to low-carbon and energy efficiency projects.”

O’Connor said the issuance of green bonds gave investors the opportunity to put their money into balanced funds that truly reflect their values.

“In the past, if you had a balanced fund in a super option you could do something responsible in the equities portion of that, but in the fixed interest portion it was very hard to make an allocation that has a responsible approach,” he said.

“[The introduction of green bonds] means that all of a sudden we’re seeing fixed interest instruments specifically targeted to responsible investments.”