Register For Our Mailing List

Register to receive our free weekly newsletter including editorials.

Home / 187

Looking behind the screens of ESG investing

Interest in environmental, social and governance principles (ESG) has been growing among investors in recent years. However, in pursuing these preferences, they can severely risk compromising their investment goals. As the popularity of investing sustainably gains momentum globally, how do fiduciaries ensure sound investment outcomes are not compromised in pursuing ESG goals?

Naïve and simplistic screening processes, for instance, can leave clients with highly concentrated portfolios that reduce the chances of them reaching their goals.

Client preferences may also differ within the ESG framework. For example, some may care more about reducing the carbon footprint than about land use and bio-diversity. Preferences around social criteria can also vary.

Simple screening processes may not work

A simple, binary screening process may not be able to accommodate the broad range of issues investors really care about. This dilemma was highlighted in the 2016 Investor Report, a landmark survey on ESG investment, published by the independent group Impact Investing Australia in collaboration with the University of Melbourne. The survey of Australian investors, accounting for more than $300 billion of funds under management, found that while more than two thirds expect ESG to grow in significance, many are put off by inadequate investment solutions.

“There appears to be an unmet need from investors for financial services and advice that incorporate social and environmental impact,” the survey found. “[But] lack of reliable research, information and benchmarks and no recognised investment framework are cited as key deterrents to investors entering the market.”

Fortunately, many of those deterrents are gradually being resolved due to greater knowledge of sustainability topics and more availability of data on companies and their sustainability credentials. In terms of benchmarks, some providers have launched ESG indexes over the past year.

More attention is also being paid to clients’ sustainability and social issue considerations, importantly without compromising long-term investment performance.

This means it is now possible to incorporate sustainability preferences in robust, broadly diversified investment solutions. If designed and implemented correctly, investors can simultaneously pursue their sustainability and investment goals.

It also means asset managers can report their portfolios’ sustainability footprint, providing detailed metrics that give investors the transparency they have come to expect from investment performance reporting.

Growth in ESG is undeniable

The amount held in core responsible investment funds rose 62% last year to $51.5 billion, according to the Responsible Investment Association of Australasia’s (RIAA) 2016 benchmark report.

The most popular strategy among the 69 asset managers offering responsible investing products was screening, both positive and negative. To ensure adequate exposure and not compromise on diversification, strategies are now available that shift capital within particular sectors from companies with the lowest sustainability scores to those with the best scores.

Using this scoring framework, issues such as land use and biodiversity, toxic spills, operational waste and waste management can be considered alongside the dominant metric of intensity of greenhouse gas emissions.

A simplistic screening method can also easily overlook potential emissions from fossil fuel reserves. So while companies with large fossil fuel reserves may not have high emissions, those stored reserves are nevertheless a source of future potential emissions and may face risk of devaluation due to governmental action or the increased availability of alternative energy sources.

A final consideration is that sustainability includes more than just emissions. Penalties can also apply to companies linked to intensive factory farming, cluster munitions and mines, child labour practices, and tobacco.

How should ESG work?

The ideal approach should systematically evaluate sustainability metrics among companies across all major industries, excluding or penalising those that rank poorly while emphasising those with higher sustainability scores.

At the same time, the strategy needs to be broadly diversified across countries, industries and companies, while targeting the sources of higher expected returns, minimising turnover and keeping a lid on trading costs.

For fiduciaries, this opens up an avenue of differentiation by allowing them to tailor solutions that satisfy client convictions around ESG issues while delivering on investment outcomes. The client discovery process is important in providing fiduciaries with a sense of each person’s wealth aspirations and requirements, in addition to their non-material goals.

In the meantime, the RIAA has published a framework to help advisers judge best practices in integrating ESG in investment strategies. These include transparency of approach, the use of systematic processes and evidence of active ownership.

Aiding transparency on the company side are regulatory pressures to improve reporting around ESG issues. In November 2016, the Global Reporting Initiative (GRI) released its new sustainability reporting standards. More than 20 stock exchanges, including Australia’s, now reference GRI in their listing requirements.

Sustainable investing has moved from a fringe to a mainstream consideration for many millions of investors worldwide. The challenge is on now for asset managers to deliver solutions that meet those non-material requirements while still meeting clients’ long-term financial goals effectively.

 

Nigel Stewart is Executive Director of the Australian arm of Dimensional, a global funds manager with assets under management of around $600 billion, about 10% of which are in sustainability or ESG strategies.

RELATED ARTICLES

Impact investing – Australian market in 2014

Beyond the acronym, navigating important ESG choices

Through the looking-glass: what counts is not tied to an index

banner

Most viewed in recent weeks

A tonic for turbulent times: my nine tips for investing

Investing is often portrayed as unapproachably complex. Can it be distilled into nine tips? An economist with 35 years of experience through numerous market cycles and events has given it a shot.

Rival standard for savings and incomes in retirement

A new standard argues the majority of Australians will never achieve the ASFA 'comfortable' level of retirement savings and it amounts to 'fearmongering' by vested interests. If comfortable is aspirational, so be it.

Dalio v Marks is common sense v uncommon sense

Billionaire fund manager standoff: Ray Dalio thinks investing is common sense and markets are simple, while Howard Marks says complex and convoluted 'second-level' thinking is needed for superior returns.

Welcome to Firstlinks Edition 467

Fund manager reports for last financial year are drifting into client mailboxes, and many of the results are disappointing. With some funds giving back their 2021 gains, why did they not reduce their exposure to hot stocks when faced with rising inflation and rates?

  • 21 July 2022

Welcome to Firstlinks Edition 466 with weekend update

Heard the word, cakeism? As in, 'having your cake and eating it too'. The Reserve Bank wants to simultaneously fight inflation by taking away spending power, while not driving the economy into a recession. If you want to help, stop buying stuff.

  • 14 July 2022

Welcome to Firstlinks Edition 465 with weekend update

Many thanks for the thousands of revealing comments in our survey on retirement experiences. We discuss the full results. And with the ASX200 down 10%, the US S&P500 off 20% and bond prices tanking, each investor faces the new financial year deciding whether to sit, sell or invest more.

  • 7 July 2022

Latest Updates

Economy

The paradox of investment cycles

Now we're captivated by inflation and higher rates but only a year ago, investors were certain of the supremacy of US companies, the benign nature of inflation and the remoteness of tighter monetary policy.

Shares

Reporting Season will show cost control and pricing power

Companies have been slow to update guidance and we have yet to see the impact of inflation expectations in earnings and outlooks. Companies need to insulate costs from inflation while enjoying an uptick in revenue.

Shares

The early signals for August company earnings

Weaker share prices may have already discounted some bad news, but cost inflation is creating wide divergences inside and across sectors. Early results show some companies are strong enough to resist sector falls.

Property

The compelling 20-year flight of SYD into private hands

In 2002, the share price of the company that became Sydney Airport (SYD) hit 80 cents from the $2 IPO price. After 20 years of astute investment driving revenue increases, it sold to private hands for $8.75 in 2022.

Investment strategies

Ethical investing responding to some short-term challenges

There are significant differences in the sector weightings of an ethical fund versus an index, and while this has caused some short-term headwinds recently, the tailwinds are expected to blow over the long term.

Investment strategies

If you are new to investing, avoid these 10 common mistakes

Many new investors make common mistakes while learning about markets. Losses are inevitable. Newbies should read more and develop a long-term focus while avoiding big mistakes and not aiming to be brilliant.

Investment strategies

RMBS today: rising rate-linked income with capital preservation

Lenders use Residential Mortgage-Backed Securities to finance mortgages and RMBS are available to retail investors through fund structures. They come with many layers of protection beyond movements in house prices. 

Sponsors

Alliances

© 2022 Morningstar, Inc. All rights reserved.

Disclaimer
The data, research and opinions provided here are for information purposes; are not an offer to buy or sell a security; and are not warranted to be correct, complete or accurate. Morningstar, its affiliates, and third-party content providers are not responsible for any investment decisions, damages or losses resulting from, or related to, the data and analyses or their use. Any general advice or ‘regulated financial advice’ under New Zealand law has been prepared by Morningstar Australasia Pty Ltd (ABN: 95 090 665 544, AFSL: 240892) and/or Morningstar Research Ltd, subsidiaries of Morningstar, Inc, without reference to your objectives, financial situation or needs. For more information refer to our Financial Services Guide (AU) and Financial Advice Provider Disclosure Statement (NZ). You should consider the advice in light of these matters and if applicable, the relevant Product Disclosure Statement before making any decision to invest. Past performance does not necessarily indicate a financial product’s future performance. To obtain advice tailored to your situation, contact a professional financial adviser. Articles are current as at date of publication.
This website contains information and opinions provided by third parties. Inclusion of this information does not necessarily represent Morningstar’s positions, strategies or opinions and should not be considered an endorsement by Morningstar.