As a global equity fund manager, I used to think the smart thing to do was always to manage client portfolios with ESG principles in mind. I have changed my view. “ESG” principles have developed against a background of international cooperation to support their adoption in the investment community. In the current uncertain political climate, it is a good time to revisit the basic arguments for and against, and to ask whether we need to change our point of view on ESG.
Active portfolio managers normally have a clear brief and a fiduciary responsibility which boils down to delivering the best risk-adjusted returns they can for their clients. So, some would ask, how can a focus on ESG be compatible with that?
People have gradually accepted the integration of certain ESG principles into investment processes now, but there are some arguments to suggest that to do so must involve an element of compromise.
Firstly, if you make exclusions based on ESG factors, surely you reduce the potential for diversification in a fund and hence increase your risk (Tracking Error) relative to the wider benchmark? Secondly, if you only go for the most compliant, squeaky-clean companies you can find, surely you will end up paying higher valuations and thereby lock yourself into lower expected long-term returns?
Both of these arguments have the ring of plausibility about them. However, in practice they do not present real impediments to the ESG-aware fund manager, particularly when we are looking at diversified global portfolios. Normally, when clients stipulate specific names or areas for exclusion, the resultant “blacklist” only makes up a small part of the investible universe so there is no real impact on portfolio diversification.
On the second point, it may be true that there is a history of some great ESG paragons that trade very expensively, but these are mostly companies that cater to a green “theme” which some investors see as a way of tapping into strong long-term growth potential. We need to look at these on a case by-case basis. Not all will be good investments.
Success vs sustainability?
People sometimes argue that we might be deliberately forgetting valuable investment principles when we embrace ESG considerations. I don’t believe that is the case, and I think that the risk and return points made above have more powerful counter-arguments on the ESG side.
Firstly, it is undeniable that more and more investors are keen to deploy their capital responsibly. As this process continues then naturally “good” ESG companies will receive a lower cost of capital than the “bad” ones and this steady move in favour of the better companies should help their returns.
Secondly, on the risk side, quite simply those more compliant companies are less likely to be penalised by government policy or by trading partners who are keen to ensure they maintain highest possible standards in their supply chains.
These two positive arguments have been enough to keep me increasingly in favour of embracing ESG considerations within global portfolios. But times may be changing. In the past we could view bad ESG practice as more than an operational risk.
However, if we are now facing a breakdown in global political cooperation, we may be seeing an increase in potential rewards for companies (and countries) that choose to ignore externalities without the accompanying risks of being penalised for doing so. The recent US withdrawal from the Paris climate agreement is a classic example of the potential payoff in the “prisoner’s dilemma” within game theory in which the party that breaks with others believes they will get an advantage but at the expense of the others.
Sustaining sustainable investing for the future
It seems that these things go in cycles and that over the long run, global cooperation to the benefit of all countries should increase. However, we cannot be sure how this will all play out. So now it surely becomes all the more important to hold to ESG best practice as a basic statement of principle - not just as a means to achieve one’s investment objectives. Adopting ESG principles in investment is compatible with - and will likely enhance - the investors’ traditional risk and return objectives.
Today active portfolio managers are under increasing pressure to prove that they are custodians of the interests of their clients. As corporate investors, we are responsible for looking after large amounts of client money as well as collectively setting the cost of capital for companies around the world, we must maintain the highest possible standards.
That is why it is time to change our view on ESG investing. It is not just the smart thing to do, not just expedient. For our clients and as responsible corporate citizens, regardless of which way the political pendulum is swinging, it is our duty to bring ESG considerations into sharper focus and bring them to the front of ours and our clients’ minds. It is time to change our perspective.
The value of investments and the income from them can go down as well as up, so you may get back less than you invest. This information is not a personal recommendation for any particular investment. If you are unsure about the suitability of an investment you should speak to an authorised financial adviser.