There has been an increasing awareness of environmental concerns and how certain industry and business practices impact environment and future generations.
With greater understanding, investors in Australia and around the world are realising they can make a difference and effect change by aligning their investment decisions with their principles. The industry has responded by developing a range of responsible investment options to meet this demand.
The responsible investment sector has experienced significant growth over the past few years. According to the latest Responsible Investment Benchmark Report, the market grew 17% over 2019 and now represents 37% or $1.15 trillion of the total professional funds under management (TAUM)1. Today many investment managers are applying responsible investment to some or all of their investment practices.
As you can see from the graphic below there are various approaches to responsible investing that investment managers can apply – from integrating a combination of environmental, social and governance (ESG) factors, to sustainability-themed and impact investing.
Today, the majority of Australian investment managers favour ESG integration as their primary responsible investment approach for constructing portfolios, with 87% of funds in Australia managed in this way. This integration of ESG considerations is usually via a focus on negative or positive screening – a process of filtering companies, industries or countries based on their values, practices and engagement in certain behaviours.
Negative screens are exclusion strategies involving the omission of specific sectors such as armaments, tobacco, human rights abuses and animal cruelty. Not surprisingly one of the fastest growing exclusions is fossil fuels with 19% of responsible investment now screened for fossil fuels.
Another approach still in its infancy is impact investing. With impact investing, positive outcomes are of the utmost importance. Investments are made into companies and funds with the intention of generating specific environmental and social impact in addition to financial returns. Impact investing is sometimes considered an extension of philanthropy.
As you can see, responsible investing can be approached through various lenses and each investment manager can define ESG in a different way. As an investor, it’s important to understand these definitions and the different approaches that can be taken to build a portfolio.
Regardless of the approach, all responsible investing involves having deep insights and specialist knowledge into country, sector and company operations. Research and investment teams need to work together to understand and analyse these behaviours and develop an appropriate investment philosophy that governs the design of model portfolios.
At Shadforth we take a holistic and evidence-based approach to ESG, focusing on both exclusion and impact strategies where available, to create diversified portfolios which aim to meet the investment needs of our clients without sacrificing on performance.
We believe you can incorporate ESG and apply an evidence-based investment approach to create portfolios with a tilt towards higher expected returns whilst reducing the overall carbon emission of a portfolio and undesirable industries. We have begun this by incorporating ESG into the fixed interest component of our investment models with further developments to come in the year ahead.
There are some risks that are specific to ESG investing due to excluding specific sectors and investments and thereby reducing overall diversification. Conversely, there are also many benefits to having your investments work ethically and responsibly.
One question that needs to be asked is whether sustainable investments offer a return premium equivalent to non-ESG investments. Whilst we support an ESG view towards investing, the empirical evidence shows that it does not, in its own right, result in a higher expected return. The underlying investments must still exhibit the sound fundamentals.
When applying ESG screens, performance may differ when compared to overall market benchmarks. For example, some ESG fund managers focus on investing in companies that have lower carbon emissions. Other ESG managers can use highly subjective thematic screens over companies that result in the portfolio being significantly different to the benchmark index.
It is important to take a measured approach to incorporating ESG into portfolios to ensure the expected return of the portfolios match the desired risk profile. We believe that responsible investing doesn’t have to impact returns, nor add additional risk or compromise the overall diversification benefits of your portfolios.
There can be a great deal of confusion for investors when navigating the responsible investment landscape, often made more complicated by the volume of jargon.
This is where your Shadforth adviser can be valuable, helping you to navigate the options to construct a diversified solution that achieves both your personal values and your financial goals.
As Jim Henson once said, ‘it’s not easy being green’!
1 Responsible Investment Association Australasia (RIAA)- Responsible Investment Benchmark Report 2020.