Edition: April / June 2016
The Rise of RI
Responsible investing (RI) widely encompasses the environmental, social and governance (ESG) aspects of investing. It has attracted increased awareness globally, particularly for retirement funds, as an investment discipline that considers specific ESG criteria to generate long-term competitive financial returns along with measurable social and environmental impact.
Set to become a major game-changer for retirement funds in the medium term (see Towers Watson Global Pension Asset Study, 2016), we’re seeing an increasing demand by fiduciaries for their asset managers to more explicitly bring ESG practices into the way they are managing retirement-fund assets on behalf of clients. This demand reflected in:
The United Nations Principles for Responsible Investment (UN PRI) first set the scene for sustainability investing in 2006. This was supported locally both by the introduction of the Code for Responsible Investing in South Africa (CRISA) in 2011, and subsequent changes to the regulation governing pension funds in SA (Regulation 28) in 2012.
These set out prudential guidelines for retirement fund investments to incorporate ESG into their overall risk mitigation and investment decisionmaking processes. As a result, the fiduciary duties of retirement fund trustees have expanded significantly and ESG factors are now seen as part of the normal delivery of superior risk-adjusted returns for the ultimate benefit of fund members.
However, regulatory impetus and global awareness aside, there is a strong case to be made for superior, risk-adjusted returns. There is growing evidence that ESG factors, when integrated into investment analysis and decision making, may offer investors potential long-term performance advantages.
Numerous studies have been conducted the world over to support the case for RI as a driver of financial outperformance. Benefits include an improved risk/return profile, diversification, and support of long-term economic growth.
According to a 2015 study by Morgan Stanley, investing in sustainability has 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.
Sustainable equity mutual funds have also been shown to generate equal or higher average returns, and equal or lower volatility than traditional funds. There is also a strong positive correlation between corporate investment in sustainability and operational and stock price performance.
In an Oxford University study (Clark, Gordon, Andreas Feiner, and Michael Viehs, 2014) several key conclusions were drawn:
Separate case studies in Australia, specifically on its sustainable superannuation funds, and in the US, are persuasive. Both studies revealed increased competitive performance by RI funds compared with their mainstream investment counterparts (SuperRatings, 2015; Harvard Business School, 2011).
The case is compelling: RI is a self-fulfilling virtuous cycle. In a simple example, firms that reduce waste and utilize natural resources more efficiently could see increased profitability through reduced costs and increased efficiency, which makes them more attractive investments and drives their share prices up, which in turn creates profitability and healthy balance sheets, increased dividend payouts, etc.
To add to the impetus, within the last month two influential inve stment ratings agencies have come out with sustainability ratings for funds. These will allow investors to see which funds hold more sustainable companies than others. Morningstar now rates over 20 000 funds, and MSCI, which launched a similar product only a few days later, tracks 21 000 funds globally.
According to research for the 2015 Sanlam Benchmark Survey, a growing number of millennial investors are expressing a desire to “do good while doing well”. Advice from today’s pensioners informs their thinking and these younger generations are becoming more critical of unethical investment behaviour. They look for financial investments that have both environmental/social impact as well as a profit motive, and more retirement funds are being set up explicitly to pursue a “double bottom line”.
In SA the retirement fund industry is significant in terms of its sca le as well as its impact on the livelihoods of working South Africans and the broader economy. The objective of any retirement fund is to provide members with a retirement benefit when they retire. But retirement funds don’t exist in a vacuum. They operate within our economy and a fund’s ability to meet its objectives is therefore inextricably linked to the growth and success of our (and other) economies.
Trustees are thinking beyond traditional approaches to asset-class returns. They have a fiduciary duty to act in the best interests of those whose assets for which they are responsible. This means anticipating the impact of future trends such as alternative energy and climate change which materially affect investment performance as well as retirees’ quality of life.
Sustainability issues should feature on the agenda of every retirement fund’s investment committee.
Ideally, retirement funds should be incorporate RI into their investment objectives and mandates to ensure their asset managers explicitly consider ESG factors. Asset managers should therefore be poised to integrate environmental (and other) risk factors into their everyday riskassessment processes and investment decisions, as core to prudent long-term investing.
As part of this, trustees may choose to invest directly in opportunities that offer both financial reward and environmental or social value. This could involve financing projects or firms that aim to preserve, uplift or rehabilitate the environment. Or, as trustees may find it difficult to predict impact on portfolios, they could outsource this process to their asset managers and asset consultants who would then incorporate ESG factors into their overall investment analysis and portfolio construction processes.
Asset managers and asset owners can incorporate ESG issues into the investment process in a variety of ways. Some may actively seek to include companies that have stronger ESG policies and practices in their portfolios, or to exclude or avoid companies with poor ESG track records. Others may incorporate ESG factors to benchmark corporations to peers or to identify “best-in-class” investment opportunities based on ESG issues. Still other investment managers systematically integrate ESG factors into traditional financial analysis and investment processes as part of a wider evaluation of risk and return. Impact investing is where asset managers select specific investments, typically made in private markets, aimed at solving social or environmental problems.
At Sanlam Investments, our partners in this field, Cambridge Associates, have identified four approaches for institutional investors to better understand and manage ESG risks: (1) incorporating environmental risks into investment processes; (2) providing greater transparency, disclosure and reporting on environmental risk metrics by asset managers, while introducing an environmental risk lens to the due diligence and monitoring process; (3) proactive hedging via low-carbon index products, derivatives, or use of active managers who specifically employ environmental metrics; and (4) policy-level exclusion of fossil fuel and other sectors (source: Cambridge Associates in association with Sanlam Investments, 2015).
The big questions focus around how to accurately assess and measure impact, and the viability of simultaneously achieving environmental impact and market-related returns. Here measurement is critical. When looking at direct ESG investments, it is easier to measure the extent to which ESG has been incorporated as the outcomes are clear. But for bigger portfolios which do not have pure ESG strategies, but rather have ESG factors incorporated into their overall assessment processes, it becomes a little more challenging.
Asset consultants could assist by assessing managers’ capabilities in this specialist area and offering guidance to asset owners. Additionally, investment managers should be able to provide effective processes to their clients and advise fiduciaries on how to implement an effective sustainable investment strategy.
The good news is that responsible investing need not generate additional costs for portfolio performance compared with conventional investments. Therefore, institutional investors should perceive this as a better way to invest, as they can achieve high performance while still addressing environmental, social and ethical concerns.
As part of Sanlam Investment Management (SIM)’s pragmatic value investment philosophy, sustainability is embedded as a core process that can result in more insightful research and a better understanding of the potential for companies to deliver sustainable cash flows into the future. By taking the long-term view, non-financial (eg: environmental) data that affects overall valuations is analysed. These issues are typically related to the quality of companies’ relationships with their broader stakeholders and their responsible stewardship of natural resources, as well as their own governance. Acting in client’s interests, an environmental attribution analysis can be performed to analyse the overall impact of investment decisions, in terms of potential environmental damage costs. SIM are also able to conduct an analysis of the carbon footprint of clients’ portfolios, should they desire. Typically this would form part of annual feedback sessions.
It is clear that industry needs to move towards providing a more complete view on financial as well as non-financial performance (corporate as well as societal/environmental value). Increasing disclosure by asset managers could help fiduciaries manage ESG-related risk exposure more effectively, optimise their longer-term investment performance, and effectively meet their fiduciary duties. Investors could consider direct, solution-oriented strategies to capitalize on investment opportunities linked to alternative energy, for example. This could include renewable infrastructure, smart energy, and energy efficiency in buildings.
At Sanlam Investments, we are trying to raise clients’ awareness around the longer-term opportunities associated with responsible investing, and to help shift perceptions in the industry. This is supported by increasing evidence of the link between good sustainability performance and enhanced investment returns. We believe that in the context of increasing social and environmental challenges (such as climate change) and growing uncertainty, the business case for responsible investing will become more visible. For truly long-term investors, integrating a more comprehensive set of risk factors and opportunity sets into investment decision-making is a sensible and necessary approach. There are sound reasons for sustainable investing and we encourage trustees to consult with us to think beyond traditional investment returns.
Sanlam Investments subscribes to both the Code for Responsible Investing in South Africa (CRISA) and its forerunner, the United Nations Principles for Responsible Investment (UNPRI). In doing so, we aim to comply with international best governance practice, in particular to promote a relationship of trust between all relevant stakeholders and to contribute to the ongoing and long-term sustainability of listed companies.