markets. Others treated it as mere green window-dressing to more profitable investment strategies. However, times are changing. The increasing concern around the world over the environment – epitomised by London's Extinction Rebellion protests in this Autumn – might suggest that little is being done to address climate change. But investors are now insisting on seeing not just a financial return from their holdings, but also a societal benefit. And many of these investments are proving just as financially attractive as traditional ones. In this guide, we find out how the ESG and thematic investment landscape has changed and we bust some of the myths surrounding sustainable investments. Elsewhere, Martin Foden, head of credit research at Royal London Asset Management, explains the firm's approach to ESG and how it strives to deliver superior investment returns.
F
or years, environmental, social and corporate governance (ESG) investing was seen as a niche interest by many in financial markets. Others treated it as
SECTOR REVIEW
ESG & THEMATICS
ESG today: how ethical investing has gone mainstream
Applying ESG analysis to corporate bonds
Four myths about responsible investing busted
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By Square Mile
By Royal London Asset Management
By Kames Capital
For professional clients only, not suitable for retail investors. The views expressed are the author’s own and do not constitute investment advice. The value of investments and the income from them is not guaranteed and may go down as well as up and investors may not get back the amount originally invested. For more information on the fund or the risks of investing, please refer to the fund factsheet, Prospectus or Key Investor Information Document (KIID), available via the relevant Fund Price page on www.rlam.co.uk
All of these companies are authorised and regulated by the Financial Conduct Authority. Royal London Asset Management Bond Funds Plc, an umbrella company with segregated liability between sub-funds, authorised and regulated by the Central Bank of Ireland, registered in Ireland number 364259. Registered office: 70 Sir John Rogerson’s Quay, Dublin 2, Ireland. All of these companies are subsidiaries of The Royal London Mutual Insurance Society Limited, registered in England and Wales number 99064. Registered Office: 55 Gracechurch Street, London EC3V 0RL. The Royal London Mutual Insurance Society Limited is authorised by the Prudential Regulation Authority and regulated by the Financial Conduct Authority and the Prudential Regulation Authority. The Royal London Mutual Insurance Society Limited is on the Financial Services Register, registration number 117672. Registered in England and Wales number 99064.
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All information is correct at September 2019 unless otherwise stated. Issued by Royal London Asset Management Limited, Firm Registration Number: 141665, registered in England and Wales number 2244297; Royal London Unit Trust Managers Limited, Firm Registration Number: 144037, registered in England and Wales number 2372439; RLUM Limited, Firm Registration Number: 144032, registered in England and Wales number 2369965.
society is extending to all areas of personal life choices and investment is no exception. Environmental, Social and Governance (ESG) considerations are no longer alien to the investment industry – indeed they are increasingly at the centre of discussions among asset managers, advisers and wealth managers and investors alike. The fund management industry is responding to this growing public demand, something which is reflected in the proliferation of funds that adopt an ESG approach. It seems an ESG investment strategy is launched on a near daily basis with one figure suggesting that the number of ESG funds available for sale in the UK has increased tenfold in the last 20 years. Admittedly, assets under management across such strategies still remain relatively low. However, flows into ESG funds are picking up steadily, and growth in assets under management is surprisingly fast, albeit from a low base. Ethical investing is not a new phenomenon: Friends Provident launched the first UK mainstream ethical fund in 1984. It was quickly dubbed the ‘Brazil fund’ with detractors saying that you would have to be nuts to invest in it due to the drain on performance its ESG restrictions were said to have. 35 years later, and these initial detractors are far outnumbered by those who point to evidence that you do not need to surrender returns by embracing a responsible approach to investment. ESG investing has clearly enjoyed a significant reversal of reputation.
onscious consumerism is gaining significant momentum. Plastic-free lifestyles, the Extinction Rebellion movement and an increased sensitivity to diversity are all manifestations of a growing public awareness of the impact of individual actions on the broader community. This desire to improve
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Victoria Hasler, Director, Research and Consulting, Square Mile Investment Consulting and Research, explains how ESG investing has evolved to become a central part of investment portfolios
Cutting through the confusion
The recent proliferation of new strategies has perhaps had an inevitable consequence: investor confusion. The lexicon of responsible investing is large with terms such as ethical, ESG, sustainable and impact used almost interchangeably by many fund managers, advisers and investors. This is compounded by the fact that there can be a significant divergence in the way asset managers define what ESG means to them, with each frequently adopting individual nuances. In recognition of this, the IA launched an industry-wide consultation on sustainability and responsible investment in January of this year. It seeks to devise standard definitions for the various approaches to sustainable investment to include terms such as ESG integration, impact investing, and negative screening. The results of this consultation will, it is hoped, bring much needed clarity to the market which in turn will help investors make informed decisions on the investment choices they take. Agreeing standard terms of reference for ESG investing is only the starting point for a series of subsequent questions that investors might have. What should the reach of ESG be and what should it include? Is it better to apply negative screens to avoid so-called ‘sin-stocks’ or embrace positive engagement to encourage business to adopt better business practices? Or is the answer a combination of both? These considerations reflect the differing expectations investors might have in seeking to make a societal difference through their investments. Some might seek to support businesses that halt climate change through a reduced carbon footprint or for fund managers to invest in ‘bad’ companies if they are actively engaged with their management to encourage improved behaviours.
Others might have strong views on what constitutes a sin stock – armaments, pornography, gambling – and expect to have no exposure to them whatsoever. What is important is that the manager expresses the way they define their investment philosophy and approach to ESG clearly to help investors navigate the wide variety of options open to them. So how does the market for ESG investing manifest itself? A traditional approach to ethical investment sees a manager applying negative screens to their investment universe. The process employed by managers using this approach may be very similar to that of their more mainstream peers, but with the addition of a filter to weed out any companies whose revenues are derived from, for example, oil and gas, alcohol, tobacco and so on. However, another investment approach which is gaining traction embraces positive engagement. At its heart, positive engagement seeks to change ‘sinning’ industries from within by rewarding good behaviour and voting against business practices that might have a detrimental effect on the broader society. An example might be investing in an energy company which derives a large percentage of its profits from oil and gas but is investing heavily in clean energy solutions such as wind and solar. In this way, advocates argue, investors can be a force for positive change in the world.
ESG considerations are increasingly not restricted to a fund level: ESG integration is a term which is gaining increased usage. This assumes that investors expect all their investments to consider elements of environmental, social and governance factors as part of their normal due diligence and investment processes. Its proponents make the case that companies that have best in class practices with reference to their corporate and social responsibilities will be those businesses which will avoid crises, both operational and reputational, that might have a lasting impact on their profitability. Indeed, this logic is beginning to be accepted by the corporate world itself. In the US, a prestigious association of chief executives known as the Business Roundtable, recently redefined the purpose of a company. In a statement signed by some 200 CEOs, it declared that companies should consider the interests of customers, workers, suppliers and communities, and aim to increase diversity and protect the environment rather than focusing solely on increasing shareholder value. Whether this improved corporate governance will produce enhanced returns remains to be seen given the long-term horizons investing demands, and it may be some years before there is conclusive evidence one way or the other. Nonetheless, it would seem that industry is increasingly listening to the over-riding public mood music.
Integrated strategies
However, this is where a note of caution must be struck. While some businesses may take a long, hard look in the mirror and decide to make a change for the better, others might react less scrupulously. Greenwashing or ‘green sheen’ is the practice whereby companies put a marketing spin on their activities to give the impression that they are more ethically or environmentally sound than they are in reality. This is where the skill of a fund manager becomes indispensable in fully interrogating a stock’s ESG credentials to ensure that it is fully compliant with a fund’s objectives. This practice of over-emphasising green credentials is not limited to business. There are some truly outstanding ESG funds available to investors, as well as asset management groups which are dedicated to embracing ESG factors across all elements of their businesses. Many of these groups and funds are doing a laudable job of delivering ethical and sustainable outcomes for investors. In doing so, they have significantly enhanced perceptions of the potential of ESG investing and raised awareness of ethical and sustainable investment strategies as compelling options for investors.
So what of the future for ESG investing? As the desire among investors to marry their financial objectives with broader social principles grows, it is likely that increasing numbers of asset management groups will integrate ESG into their processes for all funds to some extent. This is likely to become a hygiene factor which investors will simply expect and certainly the trend is towards a market which embraces positive engagement rather than a preference for negative screens. As ever, performance will be under scrutiny which raises another challenge, particularly when assessing strategies that follow an impact investing philosophy. It is relatively straightforward to assess performance in monetary terms. It is a different thing altogether to measure the non-financial benefits that ESG investing can provide, since arguably it is the more altruistic philosophy directing an investment that investors prize as much as its pure financial returns. Measurement of this is currently more art than science. However as the market develops, investors will start to demand clearer reporting on the non-monetary elements of investing, something to which asset managers will have to respond. There is no doubt that ESG investing is now mainstream. More than ever people are aware of the impact for good or bad their personal decisions can have on society as a whole. The asset management industry has reacted accordingly in bringing a wide and diverse range of strategies to the market. As ever, with greater choice comes the need for greater attention to fund selection and an ability to assess differing vehicles and their objectives, both monetary and non-monetary. Regardless, there has never been a more exciting time for those seeking to invest in ESG funds and for those companies able to offer them.
A sustainable future
Victoria is Director of Research and Consulting, after becoming Head of Research in December 2014...
About Victoria Hasler
Deep trouble:
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Sources: (1) Preqin (2) Preqin, HFRI, J.P. Morgan Asset Management. Fundraising categories are provided by Preqin, and represent their estimate of annual capital raised in closed-end funds. Hedge fund fundraising numbers are represented by net flows and come from HFRI.Data are as of December 31, 2018.
reinsurance, asset backed securities or aeroplane leasing – others can provide welcome diversification to plain vanilla portfolios. And in times of market stress, a diversified approach is much needed to help boost returns and smooth losses. In this guide NN Investment Partners discuss the value of factor investing, and how the best factor strategies have a sound economic underpinning without being over-engineered. We also hear from Natixis’ UK sales head, Darren Pilbeam, who discusses how alternative strategies can provide a different lens through which to view market volatility. Alternatives do carry with them associated complexity and a lower level of regulatory oversight. So they are not without their challenges. But in a world of lower growth, a good deal of uncertainty and the feeling that traditional investment options are under delivering, alternative investments may just be the answer.
onscious consumerism is gaining significant momentum. Plastic-free lifestyles, the Extinction Rebellion movement and an increased
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Victoria is Director of Research and Consulting, after becoming Head of Research in December 2014. She is a member of the Executive Management Team, which provides input into the strategy and focus of the business. Victoria is responsible for managing and developing the research team, in addition to focusing on fixed income fund research and looking after clients. Before joining Square Mile Victoria worked for Brewin Dolphin as a fund analyst. Prior to this Victoria was a Fixed Income Investment Manager at Rothschild Private Bank and a Fixed Income Analyst at Merrill Lynch. Victoria holds a BA (Hons) in Economics with French from the University of Durham, the Investment Management Certificate, has passed the CAIA exams and in addition is a CFA charterholder.
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“There are some truly outstanding ESG funds available to investors, as well as asset management groups which are dedicated to embracing ESG factors across all elements of their businesses”
However, almost inevitably, where groups detect a demand for a certain type of product, there is the temptation for them to jump on a bandwagon where arguably they do not deserve a place. Given this, as with any investment, it is important that investors carry out proper due diligence and research to ensure sure that the funds they are investing in meet their desired outcomes, be they monetary or otherwise.
More people than ever are aware of the impact for good or bad their personal choices can have on society as a whole.
Martin Foden, Head of Credit Research at Royal London Asset Management, explains how ESG and credit analysis must be integrated to achieve superior investment returns
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Our investment process for our sustainable fund range has key cornerstones that, critically, are specific to the asset type being considered...
Our sustainable investment process
Our investment process for our sustainable fund range has key cornerstones that, critically, are specific to the asset type being considered:
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Two of these funds celebrate their 10-year anniversary this year. You can find out more about the Royal London Sustainable Diversified Trust and Royal London Sustainable World Trust as well as our full range of sustainable funds on our website
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We believe it is hard to outsource effectively the analysis of ESG risks to third parties. As well as the limited scope of equity-based platforms, the apparent simplicity and convenience of an ‘ESG score’ often fails to capture the vagaries of the real world and the sheer idiosyncrasies of credit. We know this inefficiency well from the role of credit ratings in the market: while broadly helpful, the over-distillation of information into one rating creates distortions that active investors can exploit. The only credible solution is proper, bottom-up research and an investment process that acknowledges the false distinction between traditional credit and ESG analysis. However, while ESG analysis needs to be intrinsic to the process to be credible, achieving this in practice is not easy. At RLAM, our credit and ESG teams collaborate to improve information discovery and dissemination, but getting the right decision-making sequence is key – ultimately, the final decisions to buy or sell and portfolio positioning are still made by fixed income specialists, given their experience of evaluating and mitigating credit risk. By way of example, the transmission of a risk through a company’s balance sheet is not a one-dimensional concept and can be materially impacted and dampened by not just who we lend to, but how and where: for instance, is our debt secured and covenanted, or are we lending into distinct company subsidiaries?
The importance of a research-based investment process
from equities to credit. Their claims about multi-asset sustainable investing appear reasonable at a high level, yet they quickly unwind for two reasons. First, only around 40% of the bonds in the sterling credit index have a public equity profile. Not only does a focus on companies with a public equity listing greatly reduce the opportunity set, it is also the very area of the market where information dissemination is already most efficient. Secondly, while there are clearly similarities, equities are fundamentally different from credit. What works for one isn’t always relevant or important for the other. For example, bondholders have no ownership of a company and therefore direct influence can be limited, particularly for larger-cap companies. More importantly, the risk/return payoffs are completely different. Unlike equities, credit risks are asymmetric: upside returns are capped, however the company performs, yet deterioration can lead to negative returns, through default, forced sale because of fund restrictions or mark-to-market losses. The relevance of ESG factors to credit investing is obvious: risk doesn’t discriminate and its origin doesn’t matter. And given the skewed nature of returns there is, arguably, no asset class to which sustainability is more important than credit.
SG is all the rage in investment management, but there are many challenges in applying ESG or sustainable considerations across asset classes. ESG investing started as an equity specialism, so much of the data and analysis used today is still centred in equities. Some investment firms use these tools and ‘read across’
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“The popularity of green bonds highlights both the opportunities and potential limitations of the increasing focus on ESG factors in fixed income investment”
‘Green bonds’ have seen huge growth over recent years. You might deduce that this reflects their effectiveness in delivering sustainable credit investment. In reality, the popularity of green bonds highlights both the opportunities and potential limitations of the increasing focus on ESG factors in fixed income investment. Any government or company that can issue bonds can issue green bonds. Proceeds are clearly earmarked for green projects, but are backed by the issuer's entire balance sheet. In principle, we are very supportive: green bonds have undoubtedly raised awareness of sustainable investing and represent a positive force for change for both issuers and investors. In practice, however, they may be an inefficient solution that isn’t in the long-term interests of investors. There are several aspects of green bonds that should be challenged. In certain cases, the ‘use of proceeds’ are self-validated or independently validated only at the point of investment. And as money is an entirely fungible concept, green lending can easily release other money for non-green projects. In fact, as most green bonds tend to be unsecured, the ability for investors to truly monitor and control the use of their funding, as well as how their bond cashflows are serviced is extremely limited. As a result, using an appropriate framework for assessing the true ‘green’ credentials for each individual green bond and green bond issuer is crucial. Perhaps the most vexatious issue with certain green bonds, however, is their negative impact on potential returns. The sheer volume of money chasing green bonds, as investors attempt to demonstrate their green credentials to clients and potential clients as conveniently as possible, can be observed to reduce the yield on labelled green bonds compared to fundamentally equivalent ‘non-labelled’ bonds.
Are green bonds the solution?
“The market's preference for convenience generates opportunities for active investors...”
Applying sustainable criteria in a bespoke way with different considerations for equities and credit unlocks very real opportunities in these very different asset classes. This illustrates how the intelligent application of sustainable factors can improve the returns we achieve for investors across our five sustainable funds while reducing risks.
Summary
More positively, the market’s preference for convenience generates opportunities for active investors who are prepared to put in the hard work to understand a company’s over-arching sustainability, or search for bonds secured on specific green assets to embed these bonds into portfolios without compromising achievable yields. An example of one such bond is First Hydro Finance 9% 2021, which is an unrated, off-benchmark bond issued by a subsidiary of French company, Engie SA. As an electricity generator with some non-renewable capacity, the parent company may have a poor ESG rating. However, its subsidiary, First Hydro, generates hydro-electric power in Snowdonia and has a far better sustainability assessment. In addition, the bonds are secured, with strong covenants and ring-fenced assets and cashflows. The attractions of a bond that may fail a traditional ESG credit screen only become apparent under our more bespoke and integrated credit and ESG approach. Ultimately, it is vital that the integration of ESG analysis does not constrain opportunity in a failed attempt to diminish risk.
We seek out companies that are aiming to create a cleaner, healthier, safer and more inclusive society.
1. Products and services
2. ESG leadership
Companies that encourage good corporate behaviour.
3. Bondholder protection
We focus on bonds with good structures, and strong security and covenants. We particularly like secured bonds and certain high-quality asset-backed securities with strong features to protect bondholders. This requires diligent credit research, but can help to improve pre-emptive bondholder control as well as dampen the impact of unforeseen ESG liabilities.
4. Effective portfolio diversification
The single most important way of reducing stock-specific risk and credit skew by investing across a range of bond issuers.
And for bonds in particular:
Aaron Burden on Unsplash
sensitivity to diversity are all manifestations of a growing public awareness of the impact of individual actions on the broader community. This desire to improve society is extending to all areas of personal life choices and investment is no exception. Environmental, Social and Governance (ESG) considerations are no longer alien to the investment industry – indeed they are increasingly at the centre of discussions among asset managers, advisers and wealth managers and investors alike. The fund management industry is responding to this growing public demand, something which is reflected in the proliferation of funds that adopt an ESG approach. It seems an ESG investment strategy is launched on a near daily basis with one figure suggesting that the number of ESG funds available for sale in the UK has increased tenfold in the last 20 years. Admittedly, assets under management across such strategies still remain relatively low. However, flows into ESG funds are picking up steadily, and growth in assets under management is surprisingly fast, albeit from a low base. Ethical investing is not a new phenomenon: Friends Provident launched the first UK mainstream ethical fund in 1984. It was quickly dubbed the ‘Brazil fund’ with detractors saying that you would have to be nuts to invest in it due to the drain on performance its ESG restrictions were said to have. 35 years later, and these initial detractors are far outnumbered by those who point to evidence that you do not need to surrender returns by embracing a responsible approach to investment. ESG investing has clearly enjoyed a significant reversal of reputation.
SG is all the rage in investment management, but there are many challenges in applying ESG or sustainable considerations across asset
Our investment process for our sustainable fund range has key cornerstones that, critically, are specific to the asset type being considered (3 & 4 for bonds in particular):
Ryan Smith, head of ESG research at Kames Capital, helps us sort the facts from the fiction in ESG
Gordon (as they say) would sell his granny. In contrast, we think there is value in judging a company on the sustainability of its products or services. Industries or companies that perform no social function are inherently unsustainable. They impose costs on society and ultimately, it is highly probable that such activity will simply be regulated out of existence. The sustainability of a company's products or services is therefore vital to its long-term strategic success. Strategic positioning and vision can be a long-term tailwind or headwind. An unsustainable product (for example, coal) is a huge strategic headache for any management team, just as a sustainable one should create a tailwind of opportunities.
There is no place for ethics in investment
including the belief that responsible investing somehow underperforms compared to alternative investment styles. Another popular one is that there is simply no place for being responsible when it comes to investing. However, the rise of companies such as Beyond Meat, which are displaying clear signs of success, are helping to change some of these ingrained biases, according to Ryan Smith, head of ESG research at Kames Capital. "There have been many theories over the past few decades about responsible investing and how it fails to offer as good an opportunity broadly to investors," he said. "However, the facts are very different. Companies which do not give any consideration to their responsibilities to everyone beyond their shareholders are increasingly in the spotlight for the wrong reasons. "Nonetheless, many myths still abound about responsible investing which must be dispelled." Here, Smith looks at some of the most common myths around responsible investing and reveals the reality of the situation behind them.
he concept of investing responsibly has been around for more than two decades, but it is only now starting to gain significant traction with the mainstream investment population. Part of the reason for this is a series of falsehoods which have taken root in the collective conscience of investors,
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This article first appeared in Investment Week on11 October 2019.
attractive risk-return profiles to working hard as a kind of insurance policy. Today many investors have recognised that a sizable allocation to alternatives can give a needed boost to portfolios. AJ Somal, a financial adviser at Aurora Financial Planning, says that among this clients: “There has been a shift to investing in alternative assets, and a move away from traditional asset classes like bonds and equities.” He adds: “My clients have been investing in property (buy-to-let), peer-to-peer lending, and buying premium bonds – with the latter to mitigate tax.” The alternative funds chosen for a portfolio depend on the role they are expected to play and how granular a portfolio manager’s fund selection and asset allocation are. Do they sit in an ‘alternatives’ allocation? Are they included under a ‘diversification’ heading? If they are more directional, do they actually sit in a portfolio’s equity risk budget?
he concept of investing responsibly has been around for more than two decades, but it is only now starting to gain significant traction with the
Myth One
“Gordon Gekko didn't do lunch and wasn't strong on ethics”
True. Thinking about sustainability, combined with other risk metrics can provide investors with powerful downside protection. However, risk is a backward-looking measure. Thinking sustainably promotes a long-term focus, helps us to avoid short-term distractions and can also be useful for identifying sources of competitive advantage. In the Kames ethical and sustainable strategies, we look for growth stock investment opportunities and typically find that these disruptive, innovative growth companies are more likely to provide responsive investment opportunities and be willing to engage and improve.
Thinking sustainably is a downside risk tool only
“It's all about avoiding controversies and disasters”
In most instances, they adopt a 'best-in-class' approach; because the best ESG companies must be the best investment, right? Maybe, but in our experience, it is often a bit more nuanced. 'Best-in-class stocks' according to these ratings also tend to be large-cap, well-known and well researched, and hence provide less opportunity for mispricing opportunity to capture alpha. Which is fine, because our focus is on the small and mid-cap space, where we believe better investment opportunities often occur. And to provide our clients with the breadth of negative screens that they seek, our ethical funds are always actively managed. Then, once invested, we take our stewardship responsibilities very seriously; meeting with management, challenging them and if we need to, selling our position.
Just invest in the best
“There are an increasing number of ESG products being launched, many of which use off-the-shelf third-party ESG ratings to construct their portfolios, or indices”
Actually, academic studies increasingly disprove this. Empirical evidence supports the premise that thinking carefully about sustainability as part of an investment process can enhance investment returns. Ultimately, investing is about employing an effective set of tools consistently in order to tip the odds in your favour. Sustainability analysis is one of these tools and it fills a key role in our toolbox, but it's one which many investors still do not consciously utilise.
Profits vs. principles
“Investing responsibly means giving up returns”
Myth Two
Myth Three
Myth Four
Dawid Zawila on Unsplash
Vlad Tchompalov on Unsplash
MYTH ONE
MYTH TWO
MYTH THREE
MYTH FOUR
