By Richard Turley
Socially responsible, ethical, sustainable are all buzz words in the investment industry at the moment. A niche area only a few years ago, new ethically focused products and funds are popping into existence at a rapid rate, while mainstream funds are increasingly trying to keep up by integrating environmental, social and governance (ESG) standards into their investment decision-making.
But what is all the fuss about, and why are environmental and social factors impacting on investment decisions?
Traditionally investment decisions were made based on a complex but rather narrow set of factors. Profit, return on investment, return on capital, gross and net yield were all seen as the core measures to gauge the success of an individual investment and the factors most likely to impact a portfolio’s overall performance.
However, the world is changing rapidly. The market-based economy of the 20th century is rapidly being replaced by a more nuanced economy that is required to take into account the social, environmental and societal impacts of its operations. Different industries have been impacted to a greater or lesser extent, but the trend is consistent across financial markets.
In recent years, asset managers, pension funds and investment companies have been burned too many times using traditional investment analysis that identified investment opportunities that were, based on the models, rock solid. This analysis, however, was flawed. It did not take into account the governance, compliance, leadership or culture of an organisation, factors that can lay dormant for many years, but when they do appear can have a catastrophic impact on a company’s share price and investor confidence.
Take Volkswagen, a profitable giant of the car industry that had largely avoided the problems of its American rivals after the global financial crisis. Investors were happy to include it as a low-risk investment in a wider low-risk portfolio. Yet the impact of Volkswagen’s compliance-avoidance culture led to the emissions-cheating scandal that has seen the company’s share price almost halve. In the long-term, it will surely take many years for its reputation to be repaired, among customers and investors alike, as fines, class actions and poor sales drag on the company over the coming years.
Trustworthy corporate brands take a long time to build based on years of good governance, treating customers fairly and contributing positively to society, but it takes seconds for that brand and consumer trust to be destroyed.
Consumers, governments and non-governmental bodies are increasingly targeting companies that have demonstrated poor governance, show scant regard for environmental standards or have records of poor labour relations. While savvy marketing and good branding allowed organisations to hide many of these flaws in the past, these tactics are now becoming more transparent, and consumers are less likely than ever to trust the corporate behemoth.
Large asset managers are waking up to the fact that their long-term objectives mean that they must pay attention to dormant issues that can rear their heads and negatively impact a portfolio in five or ten years’ time. For example, the Canadian Pension Plan Investment Board stated in its 2014 report that “we consider responsible investing simply as intelligent long-term investing. We believe that firms that take the opportunity to manage ESG factors effectively are more likely to endure, and create more value over the long-term than those that do not”.
Investors are wise to pay attention to ESG factors. In today’s world of social media, a company’s brand reputation can be torn to shreds with a few inopportune words in a media interview, let alone a full-blown disaster due to corporate misgovernance. Poor company culture can have a long-term impact on its brand and a very real short-term impact on a company’s share price if something goes wrong, which it inevitably does if ESG factors are ignored for long enough.
Investors have, therefore, been demanding more choice and a certain insulation from companies with a flagrant disregard for societal norms. This is where the responsible investing industry has started to fill a gap in the market and forced mainstream funds to redesign their investment decision-making practices.
This is not only in the choice of companies in a funds portfolio. Managers are also starting to take more active roles in advocating for companies to implement anything from a split of the CEO and chairman roles to producing a sustainability report for the first time. Active investing requires the investor to pay more attention to the minutiae of corporate governance and to agitate for change where flaws can be seen. Groups of investors can now place significant pressure on an organisation to change its behaviour, update its policies and procedures, or change its leadership.
Socially responsible investing is not a new phenomenon; it can arguably be traced back to religious organisations in the 19th century, such as the Quakers, who avoided “sinful” investments in companies involved in guns, liquor or tobacco.
However, the 21st century has seen a realisation among mainstream investors that not only is responsible investing good for the community and environment, it is also more profitable. Adding an additional lens to investment decisions, one that identifies those risks that do not necessarily appear in a company’s financial statements, is now being seen as critical to the long-term success of an investment portfolio.
This is not a trend that companies and investors are going to be able to ignore. The Financial Stability Board, an international body that monitors and makes recommendations about the global financial system, recently announced the appointment of experts in responsible investment, sustainable finance, risk management and climate change to head its new task force on climate-change-related disclosures. This task force will create a set of consistent voluntary disclosures for use by a company’s investors and insurers to understand an organisation’s environmental credentials. Although voluntary, the pressure on companies to begin reporting on these measures will be strong, given the now global focus on climate change from governments and consumers alike. This will require far greater transparency over the operations and governance of an organisation, allowing investors to make more informed decisions.
Generational changes are also impacting investor behaviour. Investment managers now say that younger investors are more likely to demand responsible investments for their portfolios. This generational change will percolate through the economy as companies that do not effectively address societal concerns will struggle to remain relevant in the long-term. Standard Life Investments cited a recent poll of UK residents that showed that only 39 percent of 18-to-24-year-olds and 35 percent of 25-to-34-year-olds were “more concerned in investing in a company that provides high returns on investment than societal/environmental issues”. This compares with 47 percent of 35-to-44-year-olds.
However, this isn’t just about investing in ethical concerns. Recent research by Morgan Stanley on sustainable investing identified that “investing in sustainability has usually met, and often exceeded, the performance of comparable traditional investments. This is on both an absolute and a risk-adjusted basis, across asset classes and over time, based on our review of US-based mutual funds and separately managed accounts (SMAs)”.
The realisation that sustainable and responsible investing is not only good for the planet and its population but will also provide better long-term returns is leading mainstream investment managers to rush to upgrade ESG policies, launch new products and generally re-brand themselves as socially responsible.
Investors now have a list of factors to add into their financial models. Corporate governance, environmental stewardship, labour relations, community engagement are all indicators of a company’s culture and its long-term success.
The United Nations Principles for Responsible Investment (PRI) launched in 2006 has been instrumental in raising awareness about responsible investment among the global investment community. They have blazed a trail in setting standards for modelling ESG factors into investment decisions, raising transparency around the capabilities and activities of its signatories and fostering collaboration between them. Indeed, the term responsible investing is an evolving term and is quite subjective and dependent on the values and outlook of the investor.
The standardisation of what it means to be a responsible investment fund or an ethical investor, and increased transparency around reporting, will help individual investors make more informed choices that meet their own value propositions.
2016 and beyond will see more responsible-investment products, enhanced sustainability-disclosure requirements for companies, and greater demand by investors for funds and portfolios that fit with specific values and objectives. New categories are also likely to emerge. Recently a trend towards impact investing has seen the growth of investments that aim not only to make a financial return but also to generate a measurable beneficial societal or environmental impact.
The development of the responsible-investment industry and its impact on mainstream investors is a wonderful thing. Allocating money to activities that are beneficial to society in addition to receiving a return will help to improve the lives of millions, and maybe save our planet.