Assyat David says you can differentiate yourself if you are able to demonstrate a grasp of responsible investment principles.
Responsible investing is becoming an important consideration as investors’ awareness and support for greater individual responsibility around environmental, social and governance issues take hold.
In April 2006, the United Nations launched six principles for responsible investing, aimed at institutional investors acting in a fiduciary role. These principles have gained support from a large number of organisations, including a number of Australian institutions that have “signed up” to the principles.
These principles for responsible investing have application for advisers and individuals who wish to consider environmental, social and corporate governance (ESG) issues alongside traditional financial factors when assessing an investment. The growing use of direct investments, and the preference by many investors to be more actively involved in the investment decisions of their portfolios, is encouraging this interest in ESG investing.
This article looks at the process and considerations that an adviser and dealer group need to address in incorporating ESG principles as part of their value proposition to clients.
THE UN PRI
In 2005, the United Nations invited a group of the largest institutional investors to develop the Principles of Responsible Investing (PRI). This group represented 20 institutions from 12 countries. A 70-person group of experts was formed from the investment industry, government organisations, civil society and academia.
The principles are based on the premise that ESG issues can affect investment performance and that appropriate consideration of these issues is part of delivering superior risk-adjusted returns.
The principles apply across the whole investment business and are not designed to be relevant only for SRI (socially responsible investing) products.
The six ESG principles developed by the United Nations are as follows:
1. We will incorporate ESG issues into investment analysis and decision-making processes.
2. We will be active owners and incorporate ESG issues into our ownership policies and practices.
3. We will seek appropriate disclosure on ESG issues by the entities in which we invest.
4. We will promote acceptance and implementation of the principles within the investment industry.
5. We will work together to enhance our effectiveness in implementing the principles.
6. We will each report on our activities and progress towards implementing the principles.
These principles from the UN do not provide guidance on what the actual ESG investment parameters should be and how to incorporate them in a business and client model. These issues need to be determined by each adviser and dealer group in line with their own principles and those of their clients.
TYPES OF ESG SCREENS
There are different approaches to screening for ESG issues, as represented in the diagram below.
Positive screens: Under this approach, the investor actively seeks companies that make a positive contribution to environmental, social and governance issues. “Best-of-the-best” companies are those companies whose activities align with the ESG principles. A pitfall of this approach is that it may not always result in a diversified portfolio, sometimes excluding entire sectors.
Examples of positive screens include rating the environmental impact, social engagement and corporate governance of each company. This involves details on the environmental and social impact of its products and services. Many companies now report on their contribution to the environment or society. A rating can be applied to these factors to allow for comparisons.
A “best-of-sector” approach is where the best companies within each sector are ranked against ESG principles. Investment choices are made from the top ranked companies within each segment. This approach provides better diversification.
Negative screens: Negative screens have their origins with the Quakers and the Methodists in the US. Companies whose business activities or products are deemed to be morally unacceptable (“sin” companies) are screened out. Negative screening is called “ethical” investment, as opposed to SRI.
Examples of negative screens include: Identify companies involved in gaming, alcohol, tobacco, defence or uranium – particularly where these are core activities.
Thematic overlay: This approach looks for outperformance from companies that address society’s needs and are working towards environmental sustainability (for example, “industries of the future”).
PORTFOLIO IMPLICATIONS
A key consideration in determining the types of ESG screens to be adopted, as well as a key discussion point with clients, is the potential implication for the client’s portfolio in adopting ESG principles in the selection of the investments.
Like many things, we can sometimes take things too far. A decision needs to be made about how far the ESG principles will be applied. If negative screens are strictly applied, then there may be a large portion of the Australian sharemarket excluded from the potential investable universe.
For example, applying a negative screen on alcohol and mining may mean excluding the resource sector, which comprises almost 30 per cent of the Australian sharemarket, as well as key retailers such as Woolworths and Coles, which operate liquor outlets. Such exclusion can have a material impact on the diversification of the client’s portfolio. An alternative approach is to set a metric around the extent to which the negative screen applies. For example, a metric may be that a company is excluded only if the “sin” activities represent more than 20 per cent of a company’s revenue.
Applying a positive ESG screen may mean that the portfolio has a bias towards small to mid-capitalised companies or to limited sectors that affect the diversification and potential returns of the client’s portfolio.
