Sustainability snowballs as asset management takes ESG to heart

When the Covid-19 pandemic spread across the globe earlier in 2020, there were predictions that the recent explosion in interest in environmental, social and governance (ESG) would be put on the backburner.

Instead, the opposite has happened: sustainable funds have outperformed and enjoyed inflows to match (see Morningstar box below) while asset management firms have stepped up efforts to incorporate ESG criteria across conventional funds.

Those who have been working in ESG for years report 2020 will go down as something of a game-changer. Henry Boucher, deputy CIO at Sarasin & Partners and manager of the Food and Agriculture Opportunities fund, has been involved in ESG since the 1990s. His firm is very much an ESG manager, he claims, in part because of the nature of its client base. 

“The majority are charities, and depending on the nature of their business, if they are an Oxbridge college they have students knocking on their doors saying divest from oil companies, while environmental or animal charities very much want their investments managed with sustainability in mind. So for 20 years we have been investing in this way because our clients demand it of us.”

But Mr Boucher says ESG has come on a great deal in 2020, and predicts that it will evolve “enormously” in 2021.

“The wider market is waking up, driven particularly by climate change, to the popular perception that investments should be sustainable,” he says. Mr Boucher points to several surveys which back this up; for example, 2019 research from the UK’s Department for International Development. Since then, an Ipsos Mori survey taken in April, when the pandemic was breaking and lockdowns were at their height, found 70 per cent of people interviewed across the world saw climate change as at least as serious a threat as Covid. 

“Climate change is clearly a big driver and that forces people to think in a different way,” says Mr Boucher. “It says there isn’t just a risk to my oil company shares because I’ll have stranded assets; rather it is a risk to all assets because there won’t be a planet left if we keep burning fossil fuels.”

In addition to this rising investor demand, fund managers are also having to deal with new regulations, particularly in Europe. The EU’s incoming Sustainable Financial Disclosure Requirement will force the industry to look at the “adverse impact” of their investments and this should go a long way to tackling the issue of greenwashing, he believes. 

“Article 4 considers the adverse impacts on the planet,” explains Mr Boucher. “If you say in any of your marketing literature that you care about the planet, then you need to prove it. You need to comply or explain. If you comply you need to provide an adverse impact report that says these investments cause this damage to the environment. If you explain, you have to say in big letters that we do not take into account adverse effects. So no room for greenwashing.”

While the EU is getting new regulations, the US is getting a new president. Joe Biden may be far more in tune with the sustainability agenda than his predecessor, but without both houses of Congress, his room for manoeuvre will be limited. 

“But he can do what Trump did — use executive orders and reverse the ones Trump made. And he can change the way agencies are managed,” Mr Boucher notes. “Trump undid it all, Biden will put it back together.” 

And although Mr Biden’s impact on policy may be quite limited, he will be able to shift attitudes. Mr Boucher believes politicians who embrace sustainability will be praised for it, and the president-elect will be another senior figure helping global leadership in this direction.

Pictet’s sustainability journey also started early, with the launch of its water fund in 2000. Since then, the firm has sought to grow and improve its range of sustainable strategies, either through thematic funds or best in class approaches, says Eric Borremans, head of ESG at Pictet Asset Management, and these now account for around 15 per cent of assets under management (AuM).

But what about the remaining 85 per cent of funds?

“In 2015, there was a realisation that successfully running environmental funds was great, but what about the rest of our assets? So at that point we progressively embarked on a journey to raise awareness of ESG risks and opportunities across all investment teams.”

Investment teams were shown the value add of looking at companies with an additional ESG lens, going beyond P&L and balance sheets, and looking at corporate governance more closely. This was formalised in 2017 with the creation of an ESG team, dedicated to working with all investment teams on ESG integration. 

“Today, approximately 85 per cent of our total AuM implement ESG in one way or another,” says Mr Borremans. “The ‘one way or another’ is important. You have to look as ESG as a set of ingredients that can be used in multiple ways and that will lead to different end results or to different value propositions.”

He gives two value propositions as an example. One where ESG criteria is binding, with portfolios that aim to actively minimalise the sustainability risks associated with ESG criteria.“Building portfolios with companies with superior corporate governance or significant exposure to the green economy aims at shielding investors from risks but also looks, in some cases, for growth opportunities associated with the transition to the low carbon economy.”

The other value proposition, in conventional strategies, is to identify sustainability risks, and invest in them, but only as long as you are rewarded for that risk, says Mr Borremans. “So we get renumerated, and because we have skin in the game we use our influence to actively engage with those companies that are risky from an ESG standpoint to try and achieve a positive outcome. That would see those risks reduced and we would benefit from the upside.”

There has always been an interest in ESG as a concept, reports Cathrine de Coninck-Lopez, global head of ESG at Invesco, but it took time to understand where it fits in within asset allocation and investment objectives and within policies.

“You have to think about ESG on a spectrum. There are so many flavours. The way we do it, we are not changing our investment objective in any way shape or form. But we are systematically incorporating ESG elements into it.”

In addition to regular training sessions with investment and distribution teams, the firm has created a research platform, Invesco ESG Intel to help its teams look at companies through an ESG lens. “Providing the right tools and resources is the first stage in getting everyone up to speed,” she says.

Although many asset managers describe ESG as an idea that took hold first in equities before spreading into other asset classes, Ms de Coninck-Lopez insists that at Invesco it really does include every single asset class. 

She describes the increasing flows into ESG strategies as a “virtuous circle”, as more money means more corporate activity addressing sustainability which then leads to tangible outcomes in the real world. 

And Covid-19 has in no way detracted from this movement. “It has been a support, a wake-up call for a lot of people. There has been decent performance for funds and corporates who are thinking about ESG. This has been key for those people who were maybe on the fence. It has been something of a test and ESG has won.” 

This has indeed been a “transformative” year for ESG, says Kenza Himmi, analyst at Mirabaud Asset Management, who  agrees that the pandemic has given things a push. 

“It looks like the Covid has increased appetite, as investors want companies with a clearer view on how they will tackle sustainability and how they treat stakeholders, customers, their supply chains and so on.”

Momentum has been “snowballing” she says, and she expects ESG to spread further into asset classes other than equities, and for there to be a greater focus on outcomes and impact. 

There is a regional bias though, says Ms Himmi, with global large caps tending to have more resources dedicated to sustainability. “It is not really the same in emerging markets, but we are finding they are starting to disclose more and incorporate this into their business models. Companies in emerging markets might have really good practices, it is just that they don’t disclose them.”

Indeed a lack of disclosure tends to be the main issue faced when rolling out ESG criteria across a fund range. She gives the example of a portfolio manager wanting to include a company in a fund, but a top down ESG screen excludes them. 

“Then it is a matter of discussion with a portfolio manager. They know the company, they have spoken to them and can vouch for them. We want to steer away from just applying that screen, and if a manager really wants to include a company, then that is when we prioritise that company for an engagement call,” explains Ms Himmi.

Engagement has been a relatively standard way of operating for certain investment approaches in the Anglo markets for decades, says Sudhir
Roc-Sennett, head of thought leadership and the ESG quality growth boutique at Vontobel, but the subjects of discussion, and pressure, are evolving and are now paired with active voting. 

Another market we see evolving is Japan, which has its own unique direction while using the same tools of engagement, he says. “In a country where the social pact is stronger than in many others, the government has encouraged engagement towards governance. This has the aim of benefitting savers following years of low returns due to inefficient capital allocation from risk-adverse and deeply entrenched managers.”

Although regulators are clearly trying to boost sustainability and reduce greenwashing, there are often ways for companies, and fund managers, to get around the rules, believes Mr Roc-Sennett. 

This makes ownership responsibility and active stewardship all the more important. 

“Active in research, active in engagement and active in voting,” he says. “A vital part of taking responsibility for anything is paying attention and being involved.  Think of it this way: if you owned an apartment as an investment and rented it out — if you did not check on the apartment, what are the chances it will be in good shape after 10 years?  Probably less than if you checked on it regularly.” 

Vontobel seeks to invest into high quality companies for long periods, and ESG is an important part of the investment process that supports the predictability and stability of growth it seeks. But one area of ESG even quality growth managers struggle with is dealing with companies where control is tied up by a single large investor, says Mr Roc-Sennett.  This is not a region or sector specific issue, he reports, although there are considerably more controlled large cap companies in emerging markets than in Europe or the US.  

“Control may be held by a family, a group of investors, or a government.  In these cases, minority shareholders have limited or no ability to affect change through their ultimate leverage, the vote,” he explains. “When the goals of investors, and the institutional goals of a controlled company diverge, it can be clear that our sense of ESG has a way to go to reach all corners of the market.”  

Going private

While public companies have been considering ESG criteria in their business models for some time now, it is only in the past few years that it has become so prevalent in private markets, says Michael Johnson, group head of fund services at Crestbridge.

This is due to institutional capital now using ESG as a primary lens when evaluating private equity firms, he reports. 

Institutional capital continues to flood into private markets in the search for higher yields and to avoid market volatility, while Covid-19 has brought the concerns raised by ESG to the forefront and in order to access this vast pool of capital private companies must align their principles with that of their investors.

 “Therefore, private companies are pressurised from a macro top-down perspective. Institutional investors demand certain ESG criteria to be met by private equity funds and subsequently look to only invest in private companies that follow similar principles,” says Mr Johnson. 

Consumers are more aware of ESG factors than ever before and are now actively researching products before purchasing or investing, he says. “Therefore, the level to which a private company adheres to a set of ESG principles often correlates with their success, and thus returns for investors. An investor can mitigate risk and better forecast a company’s longevity by actively studying their ESG strategy.”

VIEW FROM MORNINGSTAR: Market turmoil moves ESG front and centre 

History may well remember 2020 as the year of Covid-19, but for those operating in the European equity fund market, it will also be remembered as the year of environmental, social and corporate Governance (ESG). 

The upward trend towards ESG has been gathering steam for several years now, but the turmoil in the markets following Covid-19, the Black Lives Matter protests and the volatility in the oil markets early in 2020 all forced ESG issues to the forefront of investors’ minds and helped further accelerate this adoption.

Net flows into European ESG equity funds reached record levels over the first three quarters of this year, while at the same time non-ESG equity funds experienced net outflows. It was noted that flows into ESG funds remained positive in Q1 as investors pulled over €50bn ($60.6bn) from conventional equity funds. In what was a challenging year, in the first three quarters, ESG equity fund assets grew 16 per cent to record levels. 

While global equities, as measured by the MSCI World Index, have rebounded following the Covid-19 panic, energy stocks, as measured by the MSCI World Energy Index remain 50 per cent down on pre Covid-19 levels. 

Given the large carbon risks associated with fossil fuel companies, ESG funds tend to underweight traditional energy stocks and overweight those with exposure to green themes, like alternative energy and electric cars. This has boosted aggregate fund performance year-to-date. 

This is true of the iShares MSCI USA SRI ETF, which beat the unscreened MSCI USA Index by an impressive 4 per cent year-to-date. Part of this outperformance can be attributed to a tilt away from traditional energy firms and towards those working towards a low carbon future. Specifically, an overweight to electric car specialist Tesla, has been a big contributor to the outperformance this year.

Indeed, a large overweight to Tesla also boosted the UBS MSCI World SRI ETF, which has outshone the broader MSCI World Index bymore than 2 per cent year-to-date. A preference for renewable energy firms like wind farm specialists Vestas Wind Systems was also supportive.

Kenneth Lamont, senior analyst, manager research, Morningstar