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Sustainable investing – how to implement it across asset classes

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| Investment Outcomes

Sustainable investing – how to implement it across asset classes

Investors who have been following our series on sustainable investing will know by now that there are three main approaches to sustainable investing: exclusion, ESG integration, and impact investing. Of the three, exclusion is the most popular among investors; it’s unfortunately also the least desirable.

Once a company is excluded from your portfolio, you as an investor no longer have any say in how the company is managed. In other words, you lose active ownership.

Active ownership: voting and engagement are powerful tools for change

Active ownership (voting and engagement) is when investors use their influence as providers of capital to a company to persuade its management to act responsibly.

Investors who are unhappy with a company’s policies can vote against them at shareholder meetings. They can also file proposals to demand change or block resolutions that they don’t like. While individual shareholders with only a small percentage of the stock may not be able to make a difference unilaterally, many investors now bank together to object to unsustainable practices collectively. This has been seen in the growth of investor associations taking a common stand on bigger issues.

A good example of where a joint resolution achieved positive change was seen at McDonald’s, which in 2017 agreed to phase out the non-therapeutic use of antibiotics in its chicken meat, and then extend this to pork and beef. This followed concerns that over-use of medically unnecessary antibiotics in farm animals was enabling bacteria to develop a resistance that was causing deaths in humans.

The more investors apply active ownership, the more effective it becomes. Active ownership can also be implemented as an overlay, which makes it one of the easiest ESG tools to apply across an entire portfolio.

Exclusion: sometimes investors have no choice but to walk away

Sometimes excluding a company is ultimately the right thing to do. A good example is excluding companies that structurally breach the terms of the United Nations Global Compact and do not show any sign of improving their practices after an intense engagement process over several years. Such breaches can involve matters such as human rights, corruption or environmental issues.

Exclusion without engagement is also preferable in certain industries, as is the case with the production of controversial weapons or tobacco, where no healthy alternative product or service exists.

Other than taking a moral stance, exclusion is also motivated by the investor’s desire to avoid companies that might suffer reputational damage and/or financial loss by inflicting environmental or social harm or whose weak governance structures prejudice its stakeholders.  As a result, these companies’ share prices run a high risk of being punished by the market, with potentially serious financial implications for the investor.

Integration: mitigating against risk without excluding

Like exclusion, ESG (environmental, social and governance) integration also has at its heart the drive to mitigate against risk. But instead of excluding certain stocks, it aims to improve the risk-reward profile of a portfolio. It does this by incorporating (integrating) ESG information that is considered ‘financially material’ to the sustainability of a specific company. What counts as material depends on the industry the company operates in.

For example, with banks, there is little point in assessing their CO2 emissions, water use or paper consumption, as there is little connection between these environmental factors and the banks’ long-term business models. Instead, it is much more useful to analyse their corporate governance, risk management processes and cybersecurity measures, as these are the factors that could affect a bank’s future success. For a utility or energy company, however, CO2 emissions are extremely important indicators, and they can have a major impact both on their long-term business models and society at large.

How is ESG integration implemented?

How ESG integration is achieved differs widely from asset manager to asset manager. Sometimes ESG integration is carried out by specialist sustainability investment teams; sometimes by traditional portfolio management teams. Some firms conduct their own sustainability research, while others rely on external analysis provided by specialist ESG research firms. A distinction needs to be made between top-down and bottom-up ESG integration.

Top-down ESG integration: Sustainability data is used to identify a theme of interest that may lead to opportunities for certain companies. Portfolio managers can then look for securities that fit into that theme.

Bottom-up ESG integration: ESG considerations are included in the process of security valuation and selection. This may be achieved by including financially material ESG criteria as inputs in the valuation model – generally on a sector-by-sector basis – or by using a non-sector-specific overall ESG score that the investment team can use in determining a security’s overall risk-return potential.

The use of ESG analysis runs alongside the use of traditional factors such as a company’s profitability, market share, cost chains, competitive position and macroeconomic risks. What makes it integrated is the systemic use of ESG factors as an automatic part of the investment process along with other metrics studied.

While ESG integration is a pragmatic approach to sustainable investing, it also has its limitations. The goal of ESG integration is predominantly financial; it does not necessarily lead to portfolios that only invest in the most sustainable companies.

Impact investing: a form of positive screening

With the third approach to sustainable investing, impact investing, investors want to make a socioeconomic impact as well as enjoy the financial returns. This is often done by targeting themes or initiatives such as the UN Social Development Goals (SDGs). While exclusions are the most widely used means of negative screening, impact investing is a form of positive screening, where the focus is on deciding what to include instead of what to leave out.

Impact investing is traditionally a niche concept that focuses on microfinance, private equity or project financing. However, in order to achieve a socioeconomic impact on a larger scale, it is increasingly being applied to mainstream asset classes, including listed equities and fixed income, for example, in Sanlam’s Investors’ Legacy range. Impact investors play an important role to ensure that the UN SDGs are met.

Myth: sustainability can only be applied to equities

There is the perception that sustainable investing only works with equities because government bond prices are more sensitive to macroeconomic issues such as interest rates and GDP growth than to company-level ESG factors. And it is hard for some investors to see how ESG issues would have any bearing on debt that needs to be repaid anyway.

When one holds the view that ESG integration basically boils down to reducing risk, a principle widely applied in credit markets, it becomes clear that sustainability is, in fact, just as relevant to the fixed interest asset class as to equities. Avoiding the losers means making a careful analysis of the inherent risk in any bond: the ability of the issuer to pay the money back, or alternatively, default. This is where ESG analysis can help.

For government bonds, countries issuing them can be assessed for their risks using a wide range of ESG criteria. In addition, a sustainability ranking on a country-by-country basis acts as an early-warning system that help spot problems or opportunities in countries before they are reflected in spreads or ratings.

A sustainability ranking on a company basis can be used for both equities and corporate bonds since the underlying data applies to the company rather than purely to the security. However, whereas analysis for equities usually seeks an upside, the focus for fixed income remains on trying to deflect any downside.

No asset class where sustainability is irrelevant

Due to the evolution of sustainable investing, exclusion, integration and impact investing can now be applied across equities, fixed income, property, private equity and commodities. There is no asset class where a sustainability approach is not a welcome driver of a better risk-return outcome.

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