Many investors took advantage of the market turmoil in March to rotate into socially conscious ESG investing.
You've probably heard the term. ESG investing integrates environmental, social and governance factors into the fundamental investment process. It may also be termed sustainable investing. It can cover several areas, but essentially, it's for investors who consider their long-term impact on society, environment and the behaviour of a business.
As citizens, individuals can express their political preferences around sustainability through the ballot box and as investors, people can express their preferences through participation in global capital markets.
Started in 1970s, the sustainable investing movement was already showing strong growth before the pandemic hit and the ESG-managed investments worldwide had reached almost US$31 trillion ($47t) by 2018, a 34 per cent increase over two years.
• Canny View: A second-wave wobble
• Canny View: The new face of wealth and legacy
• Canny view: Don't confuse gambling with investing
• Canny View: It's near impossible to be right twice - Nick Stewart
But one key question investors face today is how to invest in sustainable companies without compromising their desired investment outcomes. For instance, how can they reduce their portfolio's environmental footprint while maintaining sound investment principles and achieving their investment objectives?
In its Global Investment Returns 2020 yearbook, Credit Sussie research institute points out that, of the seven broad ESG strategies identified, negative/exclusionary screening is the largest ESG category worldwide. Traditional exclusions were of so-called "sin" stocks, such as tobacco, alcohol, gambling and they have only a small weighting in the world index.
But the returns in some sin categories are quite interesting. Since 1900 in the US, the best performing industry per one dollar invested is tobacco. In the UK, the best performing industry per one pound invested was alcohol.
Also time brings change on how investors view various other sectors. In recent years, there is an increasing pressure from the investors to make large-scale exclusions, and climate change is leading to demands that fossil fuel stocks be excluded from portfolios.
Warren Buffett, who needs little introduction, does not believe in ESG investing. One of his companies runs wind farms but insists it wouldn't be doing it without the tax credit involved. Buffett's belief is that government should be behind change, not capitalism.
"It's very hard to do. If you give me the 20 largest companies, I don't know which of the 20 behaves the best, really. I've been a director of 20 publicly owned [companies] and I think it's very hard to evaluate what they're doing ."
Even if Buffett did know who was behaving the best, he believes he and his fellow managers are stewards of their investors' money, not moral arbiters on what's best for the world.
The race to be seen as green has created some issues. One is the lack of standardisation in ESG classifications or ratings.
For example, Norway's sovereign wealth fund is the world's best-known ESG investment vehicle and yet the financial regulator in Norway has pointedly reminded investors about the "greenwash". Morten Baltzersen, the head of the Financial Supervisory Authority in Norway suggested there is the risk companies and funds overstate their various environmental and ethical credentials to attract money flows.
That potentially highlights Buffett's point. Companies need to be rated on various metrics for their environmental and ethical credentials.
Organisations providing ESG rankings include major index companies such as MSCI and FTSE Russell; standalone providers, some offering a full-range service, such as Sustainalytics, and others focusing on specialist niches such as emissions; rating agencies, such as Moody's and S&P (who are also index providers); and financial data companies, such as Refinitiv, Morningstar and FactSet.
A cynic might note, that's eight companies offering their services to provide ESG rankings.
And this isn't an exhaustive list. Ratings agencies and data companies don't generally operate on a charitable basis. As noted, nor do they offer standardisation.
As Credit Suisse points out, MSCI rates electric carmaker Tesla as the top car company for sustainability. Sustainalytics ranks Tesla mid pack, while FTSE ranks it the worst car company. Each of these ESG ratings of Tesla are done through a different lens. This confusion is common across many companies.
Sustainability's 2020 Rate the Raters report offers further insights and gets into some of the problems investment managers are seeing with ESG ratings. Some of the problems currently include old and inaccurate data, lack of consistency, inexperienced research and ratings staff and ESG ratings being distilled down to one score.
As anonymous investment professionals noted about ESG ratings:
"They are the best mediocre house in a bad neighbourhood… not great quality. ESG ratings oversell massively what they can do, not transparent about the problems… machine-generated reports."
"We have had instances where we put our analyst and the ESG research firm analyst on the phone together. We often find that 9 times out of 10 our analyst will just have more information than the rating provider and will direct them to a report or data point they may have missed."
And that explains why many investment managers use a binary "in" or "out" screening process, which can lead to diminished opportunity for diversification and may reduce the reliability of capturing higher expected returns.
But as a financial adviser, I think it's important to have an approach designed to preserve diversification across the portfolio and within sectors while accounting for the reality that some sectors tend to be more significant contributors to emissions-related environmental concerns.
For all investors, ESG investing is a personal choice. It's not wrong for investors to structure their portfolio in a way that helps them worry less, whether that be due to their level of risk, or the ethical credentials of what their portfolio is invested in.
• Nick Stewart is an authorised financial adviser and CEO at Stewart Group, a Hawke's Bay-based CEFEX certified financial planning and advisory firm. Stewart Group provides personal fiduciary services, wealth management, risk insurance and KiwiSaver solutions.
The article is prepared in association with Mancell Financial Group, Australia. The information provided, or any opinions expressed in this article, are of a general nature only and should not be construed or relied on as a recommendation to invest in a financial product or class of financial products. You should seek financial advice specific to your circumstances from an Authorised Financial Adviser before making any financial decisions. A disclosure statement can be obtained free of charge by calling 0800 878 961 or visit our website, www.stewartgroup.co.nz