Modern Portfolio Theory, introduced by Harry Markowitz in 1952, has provided the lens for the way investments have been viewed for more than 60 years. In its most basic sense, it suggests the most efficient portfolio is one that maximises the return at a set risk level. Despite its success, it does have some drawbacks, most importantly the assumption that investors solely focus on the risk and return of their investments. There is little to no consideration to what the environmental, social, and governance (ESG) and other sustainability-related effects of their investment decisions are in the long term.
ESG-based investing is based on the growing belief that ESG factors are increasingly important in determining an organisation’s financial performance. Traditional investing promised to deliver value by translating investor capital into investment opportunities that carry risks commensurate with expected returns. Sustainable investing adds value to this by combining ESG considerations to improve the portfolio’s long-term results while achieving the goal of sustainability.
ESG-based investing is not a new concept. Religious and ethical beliefs influenced investment decisions hundreds of years ago. Muslims established investments that adhered to Shari’ah law, which included interest prohibitions. Quakers and Methodists created the first ethical unit trusts in the United States and the United Kingdom, again based on an exclusion principle. The growing importance of corporate social responsibility and social sustainability has raised investor awareness of the importance of ethical market participation. Following the release of the Principles for Responsible Investments (PRI) in 2006, which is a set of United Nations guidelines, ESG investing has officially entered mainstream investing discourse.
Growth in interest in ESG-based investing
In 2020, ESG investing grew by leaps and bounds. According to Google Trends, the topic ‘environmental, social and corporate governance’ has never been as popular as it is today.
The growth in signatories of the United Nation’s PRI indicates that investment organisations have increasingly been committing to integrate ESG considerations in their processes. It has grown at a 16% compound annual growth rate in the 10 years to 2019. More recently, this has accelerated: in the first half of 2020 alone, the number increased by 28% to more than 3 000 entities, and the assets under management (AUM) of these entities grew 20%, to more than US$100 trillion1, boosted by demand as well as strong relative returns.
In a practitioner survey of 2 800 CFA Institute members in March 2020, a total of 85% said they take E, S, and G factors into consideration in their investing, up from 73% just three years ago. The largest increase was consideration of environmental factors.
Is this a short-term fad or long-term fundamental change in investment management practices?
Is this growing prominence of ESG investing due to people jumping on the new ‘bandwagon’ within investments, or is it rather a result of a shift in mindset? There are arguments on both sides. While there is some element of ‘fad’ underpinning the current trends, we believe it will turn out to be the ‘new normal’ in investment practices in the same way that risk- adjusted optimisation is standard practice in portfolio construction.
What is the evidence for ESG becoming part of normal investment practice?
While there has been growth in the interest of ESG factors within the investment process, it is not limited to interest only – there is actual growth in such investments, as indicated in figure 4.
There has also been a movement within meetings with external analysts and shareholders, where discussions with management have focused on ESG matters. These are two separate avenues for investment managers to influence behaviour.
From the perspective of external investment analysts, two recent examples include Sasol and Nedbank. Sasol was pressed at a broad analyst meeting to put a climate impact-management policy in place. The company subsequently delivered on this, but not in a completely satisfactory way – and the pressure continues to be applied on the management team in these meetings. The Nedbank example was more positive in terms of outcomes. The chairman was particularly proactive on ESG- related issues and informed investment analysts of all policies completed and that were to be engaged on in future. He was the first to inform analysts that they would not be investing in new coal or carbon-related projects in the future.
From the perspective of shareholder meeting voting, the Standard Bank and BHP Billiton examples stand out. There were demands from shareholders at the most recent annual general meeting (AGM) that Standard Bank publish climate policies and institute systems to measure carbon intensity in all their loans and investments. The first system proposed by management was passed, but the second one failed on the basis that it was impractical from a cost/benefit analysis. In terms of BHP Billiton, the company was pressured to resign from the membership of all industry associations involved with lobbying that is inconsistent with the goals of the Paris Agreement. While rejected by the shareholders as being impractical, it highlights how votes at AGMs are increasingly being used to hold management to account for ESG-related issues.
According to Deloitte Centre for Financial Services, by the year 2025, about 50% of AUM in the United States will be ESG- mandated funds. The company has a view that investment managers will launch a record number of new ESG funds to meet this target and the increasing demand for these funds.
What are some of the potential barriers to ESG becoming part of normal investment practices?
A study by EDHEC Business School’s Scientific Beta analysed the returns of equity strategies focused on ESG goals. The study revealed no outperformance when these returns were adjusted for risk. This challenges the claims made of a positive outperformance by industry participants. The study further added that ESG investing didn’t provide significant downside risk protection either, despite the risk enhancements this investment approach is supposed to provide.
Another view provided by the Evidence Based Investor is that, irrespective of the principles and good intentions in place for investors, ESG is susceptible to marketing opportunism. These funds are at risk of being overpriced as many fund providers may claim that a fund may be the first of its kind with no competing funds for the investor to choose from. Investors should be aware of the problem of ‘greenwashing’ and how to spot and avoid it.
Another academic perspective noted that ESG-based funds had outperformed relative to their non-ESG counterparts. However, upon closer inspection, it was noted that these funds were heavily invested in tech companies and it was difficult to attribute the outperformance to what most would consider being ‘proper’ ESG factors. It is also made the point that positive liquidity and money flows into these investments would lead to positive relative returns due to the positive effect of these flows on the companies’ prices – something that had nothing to do with their underlying investment characteristics.
Ultimately, ESG investing has an inherent focus on sustainability and overall positive effect on the world we live in and is expected to be a source of return in the future. If the hype behind the growth of ESG-based investing is based on capturing the most upside, then there is reason to believe it might be a short-term fad. However, the growth in ESG generally looks like it is due to a change of investors’ mindsets, as the negative implications of ignoring these factors continues to grow.
At Momentum Investments, we take responsible investing seriously, and have several funds dedicated specifically to socially or environmentally responsible investing.
Our impact investment funds focus on three areas – alternative energy, social infrastructure, and diversified infrastructure. These investments are closely linked to very specific United Nations Sustainable Development Goals (SDGs), to which Momentum Investments subscribes. This is a level of commitment that we think is unique – not only in how we’re investing, but in how we match these investments specifically with common, international goals for a better, more inclusive world.
This kind of strategic, goal-orientated investing means that our investors can hold us accountable. This makes for better decision making, and better-quality conversations with our clients.
Mike Adsetts (Deputy Chief Investment Officer), Paulina Mwenda (intern) & Bafana Motshweni (intern)