ESG principles move into the mainstream

Private banks and asset managers such as F&C, Robeco, Sarasin and Vontobel, that have developed a presence in socially responsible investment (SRI) and run specialist units to shape in-house fund ranges and offer screening and engagement services, are experiencing increased demand for their products.

“It’s an idea whose time has come,” says Burkhard Varnholt, chief investment officer of Bank Sarasin, which has put a social and corporate governance filter over all of its investment products.

“Demand from the wealth space has picked up dramatically in the last five years, growing in an exponential fashion year after year. Suddenly we are receiving unsolicited requests. There is increased awareness of climate change and the world as a global village.” Sarasin’s SRI-related business has tripled since the end of 2006 to $11.5bn (€9.3bn).

Rising demand

Like others, Mr Varnholt believes that in the not too distant future, integrating environmental, social, and corporate governance (ESG) principles in investment will become the norm.

Robeco’s Responsible Investment Department has for five years been conducting overlay services for existing portfolios, and demand has been climbing on all sides.

In this arrangement, explains Wilco Van Heteren, senior engagement specialist at the unit, the fund manager picks the stock holdings, and the engagement provider then talks to the company managements about certain aspects relating to the environment, human rights or corporate governance. Robeco sets particular targets (five or six on average) for each company for achievement in a timeframe of on average three years.

The process is much more than a few letters or phone calls. This dialogue might involve clubbing together with other investors or exerting shareholder influence at annual general meetings.

Examples of the themes Robeco’s Responsible Investment Department has been taking forward include water management in textile producing firms and retailers that sell this clothing, and also in beverages and food. Another research area is the impact of obesity – a few years ago there was hardly any response from investors to this but there are now specialist healthy living funds.

The engagement units often work closely with government bodies on policy change and are in a position to shape the industry. Karina Litvack, head of Governance & Sustainable Investment at F&C, is currently working with parties looking at giving the EU a role in stabilising the carbon market, similar to the task central banks take on for interest rates, ensuring stability by setting targets and releasing credits for auction.

Measuring the positives

More recently asset managers have developed ESG integration, where stocks are also chosen with reference to ESG factors that have a material impact on the business’ long-term performance. The reputational risk of poor ethical standards are obvious – remember how the media panned Nike for using child labour at its factories in Vietnam and Bangladesh – but the impact of the positive attributes are harder to quantify. Fund performance comparisons are also difficult to conduct and depend on the eligibility parameters used.

Accelerated demand for ESG investment is partly a result of its growing validation in performance terms, and investor interest can be ‘quite tactical’, Mr Varnholt says. “We’ve been doing it for 20 years and whatever way we slice the performance numbers – over one, three, five or 10 years, in discrete periods or on a rolling basis, the results tend to be better than the broader market.”

Compared with MSCI World, the Sarasin Global Sustainability Equity Fund rose 45 per cent compared with the markets’ drop of 35 per cent, an 80 per cent compound differential.

“This is partly because (qualifying) companies are better managed, and the small cap bias helps, but these factors don’t explain the whole difference,” Mr Varnholt adds. “The key driver to steady investment performance is the avoidance of big losses. Also, social and environmental

analysis forces the fund manager to take a long time horizon and be more risk conscious.” Sarasin’s team has avoided BP, for example, and with it the oil major’s recent share drop. They also avoided investment banks in 2008-9, because little attention was being paid to corporate transparency.

Government regulation

Some characteristics of SRI business are very powerful drivers of performance, none more than the opportunity to invest in business activity supported and incentivised by Government regulation. Building and construction produces massive greenhouse gases but government incentives worldwide encourage property owners to conserve heat by taking certain measures such as improving insulation.

Pre-empting regulation can be even more rewarding. For example, the pulp and paper industry in Brazil is based on huge plantations in the South West and South East of Brazil, that could become a grossly undervalued asset if their carbon absorption qualities become valued as an asset through the carbon trading permit system, so providing the paper manufacturers with a second income stream that has not yet been factored in.

Eric Borremans, BNP Paribas IP

The movement has come a long way from its roots in negative screening, and its early concentration on clean energy and environmental funds, where the limited universe of eligible stocks hampered performance. Too much cash still chases certain sectors – historically solar power and biofuels both reached unrealistic valuations and electric batteries could prove the next bubble.

There is more liquidity in mid and large cap stocks in mainstream Best in Class portfolios and in thematic funds, and this weakness is gradually being addressed organically as the universe of businesses operating in related fields becomes larger.

Thematic funds such as the F&C Global Climate Change fund focuses on equities that will benefit from mitigation, such as where CO2 emissions are being reduced, and adaptation, the changes society must make to deal with extremes in climate such as flood control, insurance, drought resistance crops and desalination. This is a broad umbrella.

For example, it could be possible to invest in financial services companies that specialise in carbon trading, and other service providers with intellectual capital developed around mitigation.

Funds with the most limited universes are naturally more volatile. In general, environmental funds perform better than mainstream indices, says Eric Borremans, head of SRI Development at BNP Paribas Investment Partners. “But there can be periods of serious underperformance, because some of these markets are still new and prone to periods of euphoria, bubble-bursting, overcapacity and slowdown in environmental regulation.

“There is certainly a wide disparity between the best and worst environmental funds,” he says. “Over the last twelve months, the best performers have risen by around 25-30 per cent, while those at the bottom have fallen by 2 per cent.”

Although most screening and engagement focuses on equities, there are half a dozen ethical bond products and a few discretionary managers run ethical mandates across all asset classes. More than one third of Sarasin’s SRI business is multi asset class mandates in wealth management.

Although wealthy investors are currently not inclined to ask a fund manager to drill down to achieve a specific environmental or ethical bias, as the sector matures there are many funds to compare for their different style biases and the quality of their research on ESG matters.

Agency Novethic in France is currently working on a certification system, initially confined to funds in France, which should be launched in the autumn. It is reviewing a number of funds and will announce which ones qualify against key criteria and the transparency of their investment process. This is a huge step forward. The funds will have to provide a report quarterly of key indicators and extra-financial indicators.

“It is the only attempt to rubber stamp SRI portfolios that meet a certain criteria,” adds Mr Borremans. “Communications about SRI characteristics are relatively inadequate so this is a real breakthrough.”

Vontobel and Sarasin have started SRI due diligence work on companies in emerging markets too, and say that relevant information is becoming easier to access. Sarasin has broadened its research into emerging markets by forging a relationship with Asset Four.

Another approach to climate change is products linked to low carbon indices which providers have designed in partnership with non-Governmental organisations such as AgriSud, GoodPlanet.org and WWF.

BNP Paribas for instance offers an exchange traded fund (ETF) listed on Euronext linked to the Low Carbon 100 Europe® Index, an index of 100 largest blue-chip European stocks on a sector by sector basis, based on their carbon emissions per million euros in revenue.

Since its launch in October 2008, the ETF has consistently outperformed its benchmark of the largest 300 European stocks, and its volatility is lower, while the carbon emission of the index constituents is on average 42 per cent lower.