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Why ESG can still play a crucial role in investor portfolios

ESG (environment, social and governance) has become a fixture of investing in financial markets over the last decade. It refers to a range of factors that can affect investment decisions beyond day-to-day financial impacts relevant to investors and companies. Examples include climate change and decarbonisation, workplace safety, board composition, as well as management remuneration and accountability.

As public awareness and interest in ESG issues have grown, it has created a wave of new investment options marketed as ESG focussed using various labels such as 'responsible', 'sustainable', 'socially aware' and 'ethical'. Despite being widely used, there are no standardised, generally accepted definitions of these terms and they can vary widely. Two products with the same label provided by different funds can have quite different portfolios drawn from very different investable universes. This requires a level of due diligence and research on the part of people considering investing in them.

ESG denotes quality

The use of terms like “ESG investing” and “ESG products” is somewhat grating for any sensible investor. It suggests a false choice between two different types of investing – one which incorporates consideration of ESG issues and another which doesn’t. In reality, investors seeking long term returns have always had a focus on investing in assets and businesses that have quality as a core tenet, demonstrated by their capacity to generate consistent, sustainable and growing cashflows and earnings in a way that balances the needs of various stakeholders. The increasing prominence of ESG into investment processes is simply the natural evolution to a more comprehensive framework for assessing quality within an investment context.

ESG labelled funds typically invest in a restricted universe relative to more mainstream funds, with exclusions or negative screens for producers of products like tobacco, fossil fuels and weapons as well as companies involved in alcohol, gambling, human rights violations or other controversial activities. In addition, these funds may be marketed as having various positive attributes in terms of sustainability objectives or other desirable features. These restrictions and attributes inevitably raise issues for investment firms or superannuation funds, their members and regulators, around the scope of the negative screens and measurement of positive attributes claimed.

Look under the hood of ESG products

It is incumbent on the investor or super fund member to check the product is aligned with their expectations; are they aware of the scope of the exclusions and the metrics used to assess positive attributes? For example, does the negative screen for tobacco apply only to producers of tobacco or does it extend to related products? Should it apply to companies deriving revenue from tobacco sales or packaging above a certain threshold? In the case of weapons, will they be comfortable investing in a company that has incidental exposure because it produces components that go into fighter aircraft? Likewise, what are the metrics used to determine the positive attributes claimed? Will the investor be satisfied with the positive attribute of the fund based on the percentage invested in ESG “leaders” as determined by a third party ESG ratings provider – noting that different providers will apply different methodologies?

For the manager, there may be higher cost in terms of compliance checking to ensure the exclusions are applied in line with the product mandate. Higher costs can mean that these products may have higher management fees impacting net returns but it’s not always so – it’s wise to always check the fees and costs attached to any product you choose.

Equally important is the effect of negative screens on investment performance. Any negative screen will by definition produce investment outcomes that deviate from that of the broader market and benchmark indices. For example, the exclusion of fossil fuel companies means that these products will have a structural underweight exposure to the energy sector, with a corresponding overweight exposure to other sectors, such as the technology sector. For most of the last decade, this has been a winning trade with the global oil price sitting above US$100/bbl in 2013 and then falling precipitously to under US$20/bbl during the Covid-19 pandemic in 2020. This was coupled with technology shares performing very strongly during this period. However, the recovery in the oil price over 2021 and 2022 to back over US$120/bbl and subsequent sell-off in technology names saw significant underperformance in these products relative to their mainstream counterparts.

Another consequence of restricting the investment universe is the potential inclusion of higher risk assets. Narrowing the universe can mean going down the quality spectrum or choosing assets that may be more volatile. It‘s important for those considering investing in these products to get comfort with the risk they are taking.

Regulators are also weighing in and we are seeing an increase in claims of “greenwashing.” While this word is relatively new, the concept it represents is the familiar one of misrepresentation or misleading and deceptive conduct. This is complicated by the lack of standardised definitions of terms like 'responsible', 'sustainable' or 'impact'. The Federal Government’s initiative to develop a framework for labelling and classification should help ensure greater alignment and greater clarity for investors.

In summary, the plethora of ESG labelled products provides people with an opportunity to invest their savings in a way that is aligned with their values. However, there can be substantial differences between different products even if they have the same label and as a result products vary widely and can be difficult to compare. As with any investment, it pays to do your research and understand the investment before making any choice.


Lou Capparelli is Head of ESG at UniSuper, a sponsor of Firstlinks. Please note that past performance isn’t an indicator of future performance. The information in this article is of a general nature and may include general advice. It doesn’t take into account your personal financial situation, needs or objectives. Before making any investment decision, you should consider your circumstances, the PDS and TMD relevant to you, and whether to consult a qualified financial adviser.



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