Making sustainability a core investment

The client base of private banks seems ideally positioned for investments based on environmental, social and governance (ESG) driven criteria. A new marker has been laid down in this sector by the United Nations Environment Programme Finance Initiative (Unepfi), whose asset management working group last year invited some of the best-known names in the private banking world to Geneva’s Palais des Nations to discuss the concept of ESG strategies. The summit led to a report on private banks’ participation in socially responsible investing. “Private bankers willing to take a leadership role in ensuring the development of products and services that respect the two ROIs - return on investment and responsibility of investment - will be serving a market where client demand is set to outstrip supply,” wrote Unepfi’s Paul Clements-Hunt. A long way to go The last definitive figures on ESG-led commitments in wealth management were released eight years ago by Deutsche Bank. The survey estimated only 4 per cent of assets of high net worth individuals (HNWIs) were invested in ESG-inclusive strategies, although at least a third of HNWIs found the ESG concept attractive. The Unepfi report acknowledges that given advancements in ESG investing since the turn of the Millennium, that proportion has probably gone up. But even if those figures stayed more or less the same, there would still be $2,000bn (E1,590bn) looking for an ESG-friendly home. Inter-generational wealth often leads to a desire for inter-generational stewardship. In many cases this is carried out through charitable endowments, sometimes advised by the client’s wealth manager – and few would want their investments to work against their charitable giving, particularly if investment income is being channeled into that giving. “A new field is developing around mission-related investments, where part of the foundation’s assets is put to work in [social] enterprises that deliver on the core foundation’s mission,” says Robert de Guigné, head of SRI and investment architecture at Lombard Odier Darier Hentsch private bank in Geneva. “We also notice that clients active in charitable or social activities tend to look to invest in the same field,” he adds. UN milestone The United Nations Principles for Responsible Investment (Unpri), set out in 2006, were a milestone in integrating ESG factors into investment risk-management processes, bracketed by studies from Unepfi, which sought to establish that ESG factors materially affect company values and then review the research to see whether that correlation was positive or negative. One assumption took over thinking around ESG: as one of the studies put it, “Naturally, performance speaks loudest for most investors.” It is a bit more subtle than that in the private client world – as the savviest private bankers recognise. “The shorter your investment horizon is, the more importance you give to the financial risk/return characteristics,” says Mr de Guigné. “The longer it is, the more SRI/ESG characteristics become important. Investors tend to associate long-term performance with SRI/ESG issues,” he explains. At first there was an ethical approach to sustainability investments, manifested mainly in retail markets. Institutional investors then started to look at sustainability investments as a global risk-management overlay to their mainstream investments. Wealthy private client eventually followed. “High net worth individuals came with the strong view that we could combine financial performance, a long term investment time horizon and sustainability,” believes Mr de Guigné. “Sustainability is not philanthropy; therefore profit expectations are essential in the development of sustainable attitudes,” he says. Andreas Knörzer, head of Sarasin Sustainable Investment - Switzerland’s Bank Sarasin published a report in November that found a positive relationship between sustainability and share price performance - agrees that “fiduciary responsibility includes ESG criteria, which impact on financial performance” and integrating ESG into investment “is not voodoo, but hard and disciplined work”. His belief is that porfolios can be managed sustainably without significant beta tilts and that sustainability means more than renewable energies and water investments and needs to be applied for all asset classes and industries. But Mr Knörzer also acknowledges that private clients “behave very differently” from institutions, and many “put ethical considerations in first place”. Counterproductive Christoph Butz, sustainability expert at Pictet Asset Management in Geneva, goes further, arguing that the new materialism is “trivializing” SRI and cutting it off from its roots. “I think using ESG concepts purely to improve financial anlaysis of companies is reductionist and counterproductive,” he says. According to Mr Butz, the ESG investor needs thorough extra-financial performance reporting, but the financial services industry has proven reluctant to embrace that because doing so would introduce “the possibility of extra-financial underperformance”. This is not only unfair – most active managers underperform, after all – it is also unnecessary: the financial return obviously has a value for the investor, but focusing on outperformance fails to recognize that social benefits have value, too. “Where we differ considerably from Unpri is that we do not claim that sustainable bets implemented in an optimized portfolio will have a short- or even medium-term positive effect on performance,” says Mr Butz. “In the short- to medium-term you can be heavily penalized by owning the most sustainable companies: an energy-efficient company will have an advantage when energy prices go up, but petrol-guzzlers will outperform with lower prices; 2007 was a very difficult year for best-in-class sustainable companies in general because tobacco, arms, nuclear and so on heavily outperformed the market while companies with strong ESG records were not rewarded because investors were more concerned with other, more relevant market forces,” he explains. Like other systematic risks, ESG factors will deliver a premium over the long-term - because our survival depends on it - but whereas investors can choose to over- or underweight equity or credit risk, for example, they would not want to underweight environmental sustainability against job preservation – even though these cannot both contribute outperformance at all points in time. “We do segregate certain ESG factors and backtest them - not with a view to throwing the non-performing factors overboard, but purely for performance-attribution for our clients,” says Mr Butz. “We found that they are cyclical. Technically, ESG is an investment style, dependent on the market circumstances.” The Unepfi’s 2007 report on ESG opportunities in private banking suggested that because the strategy is “unproven”, intermediaries were wary of risking client trust with anything beyond “small allocations in satellite portfolios”, thereby inhibiting “a holistic approach”. The reality is that private clients have only a limited scope for their SRI/ESG investments today and that thematic funds are often the most favoured investments. Non-specialized investment funds also exist. SRI/ESG issues can be fully integrated in their investment process if the client does not have any specific themes in mind. That is how Mr Butz describes the Pictet approach: the bank starts with the client’s risk budget, usually a tracking error, and packs as much sustainability into the portfolio as possible while staying sector- size-, country- and style-neutral. That makes it all the more courageous for Mr Butz to be so candid about the risks sustainability poses to medium-term performance, because they will potentially spread through the client’s entire portfolio. Balancing that out is the theory that it enables investors to apply their ESG principles in a properly-diversified way. These “best-in-class” portfolios can look odd to the 100 per cent-committed ESG investor, as consultants Holden & Partners observed earlier this year after trawling through the major SRI/ESG funds available to UK investors and finding oil majors, supermarkets and mining companies regularly appearing in top-10 holdings. But, as Mr Butz points out, a thematic investment in a wind-turbine manufacturer is also keeping steel, copper-mining and cement companies in business, so you may as well not only invest in the best-in-class wind-turbine manufacturer, but also support the most ESG-friendly heavy-industry firms that supply them. Shareholder activism This approach, as Unepfi observes, requires commitment to go beyond merely under- or over-weighting stocks into the realms of shareholder activism – integrating the “G” with the “E” and “S”. “We are starting to see activist funds and also investor services helping clients exercise their voting rights,” says Mr Guigné at Lombard Odier, whose partnership with Generation Investment Management allows the generalist Swiss private bank to benefit from what it claims to be “some of the best expertise in the world for that specific type of investing.” Expertise in all aspects of the ESG process counts, as new research from ESG research consultancy RImetrics makes clear. When they rated global asset managers stewarding more than $12,000bn of investors’ assets on strategy, engagement, integration, voting and transparency and accountability, they found a lot of dispersion between the best and the worst managers, and even major variations between individuals within the same firm – good practice being wasted. Indeed, whereas on average managers scored pretty well on engagement and voting, they scored least well on integration. “What we would want to find is asset managers being very good at bringing all the knowledge their research processes can gather into their investment processes,” says RImetrics CEO Jonathan Horton. “Otherwise they’re wasting time and money doing the research in the first place.”