Ethical investing's re-branding is actually one of substance

John Authers, Financial Times, 26 October 2016

Investment, like many other products that need to be sold to customers, is about marketing and branding. Find the right catchword or slogan and the brand might catch on. And this is not just about appearance - find the right way to re-brand, and you might well also find the critical change to your product that will give it appeal, and deliver value to customers.

In that context, note that it is possible that the field of what was once known as "ethical" investing may be at the early stages of a new makeover. Once thought of as a form of risk mitigation (nobody wants to own the company that commits the next big scandal), it has become an attempt to generate a superior return. In its old form, as a screen to exclude "sin" sectors such as tobacco and alcohol, academic research shows that it signally failed - excluding the sin stocks merely made them cheaper for those with fewer scruples, and the net result was that ethical funds underperformed.

Now, after ethical investing has been superseded by periods as SRI (socially responsible investing), and then ESG (environmental, social and governance), and sustainable investing, a new word is appearing amid forest of acronyms: engagement.

That word recurred time and again at the FT's conference on sustainable investing in emerging markets, held earlier this week in London, and it makes a deal of sense. From a marketing point of view, there is nothing much wrong with ESG at present. The amount of institutional money managed according to some kind of environmental or social mandate is continually growing, and budding academic research is showing that it can actually make money. Companies that show up with good sustainability practices, for example, tend to outperform in the long run.

Wall Street and the City have spent the last few years building up their ESG practices. ESG is also seen as a defense of the active management industry against passive investing, although it is also now a focus of indexing groups. All the main indexing groups have a suite of indices that purports to capture ESG factors best. In this way, ESG is being treated almost like a "smart beta" risk factor, that can generate returns and take advantage of a market anomaly, like value or momentum.

Now a focus on engagement could rescue it as a form of truly active management. The hope is that it can be a strategy that both makes money for savers, while helping to improve the world into which they will eventually retire, and which their descendants will have to inhabit.

Elroy Dimson, financial historian and head of the advisory committee of the Norwegian sovereign wealth fund, puts the argument this way: "The argument in favour of intervening with companies is that if you can persuade a company to behave in a way that is more appealing to investors then the price will go up. Those who engage with companies have an opportunity for superior returns. Those who ignore companies and veto them will be too late to the party."

His own research, with Karakas and Li and published last year, used data from one large institutional investor to show a marked outperformance by stocks it held, once the investor had successfully intervened on an environmental or social issue, such as reducing carbon emissions targets. There was no downside; if the engagement was unsuccessful, the company merely tracked the index. Significantly, there were no such clear-cut returns after engagements on corporate governance issues.

This shows a difference between engagement and the approach generally known as "activism", where investors take stakes in a company, and then enter into often aggressively hostile fights with the board. This demanding approach is far less likely to work in emerging markets, where many companies are still controlled by their founding families, and where the local regulations are often unhelpful to minority investors.

Robert Petty, founder of Clearwater Capital, a Hong Kong-based credit fund, and also head of the Emerging Market Private Equity Association, suggests that in private equity, engagement on such issues is part of the job of helping the founders make a good exit price. Once established with a seat on the board, or as a major lender, it becomes easier to visit a real estate site and say "How come they aren't wearing helmets?" or "Why are they wearing sandals?" Engagement like this, he says, has a role - "it's not just about activism, or vetoing an investment altogether for ethical reasons."


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