We firmly believe that active managers adding environmental, social and governance (ESG) analysis improves their investment process. An understanding of ESG issues helps to manage risk and has the potential to add alpha.
Dialogue on these issues with managers of funds we invest in is therefore a key part of our approach to portfolio management.
However, using ESG criteria is not straightforward. ESG factors are part of practically every aspect of a company’s operations. Just bolting these criteria on afterwards can mean the results are less than satisfactory. That’s because, if considered an add-on, they will crop up as complications producing arbitrary results, which often seem unrelated to real-world issues and specific investor concerns.
Unsustainable ESG ratings
Attempting to fit fixed-rule systems to an area undergoing transformation is always going to be problematic and ESG ratings indices often produce a bewildering lack of consensus over what does or does not fit in the arbitrary limits. This means the degree of commonality for ESG stock market indices is surprisingly low. Another key issue is that because of the complexity, both investors and companies can see little connection between the desired outcomes and the index restrictions.
The problem is not lack of data. In fact, the availability of corporate information has blossomed but the use of this data and the backward-looking focus of it does still bring challenges for stand-alone adoption.
New regulations only add to the confusion
The same issue, of creating a fixed-rule system to cover a transforming market, also applies to regulation. The ESG area has been led by investor and broader public interest, rather than driven by regulatory edict. Despite the best efforts of the regulators to catch up, we believe that this will continue to be the case.
Proposed new regulation in the UK is designed to regulate the use of sustainability terminology by funds. As well as focusing on funds that are driving change it also intends to tackle unproductive ‘green-washing’ labelling. However, it does that partly by changing the definitions of existing terms and by introducing yet more terminology and labelling. So ‘Responsible’ is out and ‘Sustainable’ will be redefined as either focus, improvers, or impact. However, this is for the UK only, and does not link up with the eurozone’s sustainable finance disclosure regulation (SFDR) designations. These also present investors with issues when using them to compare investments. What one group class as Article 8 fund, will differ from another group and may also differ from your own criteria. Despite the regulator’s best efforts to create some form of transparency, there is no quick replacement for doing your own analysis.
For change to happen, we’re going to have to be part of that change
We believe that it all comes down to engagement. That regulations and benchmarks are poor indicators. You need to set out your own objectives and get yourself a seat at the table.
Engagement works because it creates real exchanges about how things can be improved. Clearly some investors and fund managers will be engaging directly with companies, reviewing their plans and actions and encouraging them to adopt best practice. But for other investors, such as we at CT Multi Manager, then it is engagement with the fund managers we invest in. Reviewing their policies and understanding how they are working and looking to evolve it as the world changes. That same engagement is replicated between individual investors and their financial advisers. That chain of engagement across individuals helps encourage and develop progress on ESG. When individually or collectively, as companies or investment funds, people can see that their work is valued and that their principles are helping achieve wider objectives.
Worthwhile investing
We firmly believe that active managers adding ESG analysis improves their investment process. We see this in terms of both managing risk and generating alpha. Avoiding ESG issues definitely reduces investment risk as these factors reflect real-world problems. However, in terms of investments, there is often more to be gained from being part of the transformation of a company, than just investing in the market leaders. That does mean taking risks and backing companies and their managements as they transform their operations, but that also produces investment opportunities.
In this month’s podcast Adam and Scott sit down with John Teahan of Redwheel Value & Income Team. As large investors in energy, banks and commodities, John explains why he believes that owning and engaging with resource-intensive companies is more powerful than blanket divestment. We explore whether the oil majors can ever be trusted to help deliver the energy transition and how groups such as Redwheel hold their feet to the fire.
