Investing for the planet's future

Once the province of small boutique managers, ESG investing has moved into the mainstream, attracting investors across the spectrum. Yet, as Jason Spits writes, it’s far too soon to state it has settled and advisers have a key role to play in unpacking this new frontier.

In an industry full of acronyms, financial advisers and their clients are coming to terms with another – ESG, short for environmental, social and governance – which is being used to define a specific type of investing that has moved from the fringes to the centre of attention.

Operating under a number of wider terms, such as ethical investing or sustainable investing, ESG has in one form or another been part of investing and financial advice for more than 20 years, but it has only been in the past few that it has moved from a niche category to a holistic approach to investing and portfolio construction.

E is for…

Much of this has been due to a greater interest in the E component of ESG, which has attracted attention as more people become concerned about climate change, according to Evergreen Consultants director Angela Ashton.

“What people are focusing on is the E side of ESG because it has so much media attention, particularly after the recent Australian bushfires. It was a growing trend prior to that, but we had a series of natural disasters in Australia which are being considered as signs of climate change and people are going to focus on that when considering ESG,” Ashton says.

“It has helped grow interest in ESG investing, more so than social and governance issues as the latter can be more esoteric for many people.”

Schroders sustainability investment director Ella Reilly says while environmental factors are usually the first thing that come to mind, events of recent years have turned investors minds to consider more social factors as well.

“In our annual ESG study among 23,000 retail investors across the globe, we saw the COVID-19 pandemic has brought a raft of environmental and social issues to the fore,” Reilly reveals.

“Nearly half of those respondents – 47 per cent – said environmental issues were a key thing, but more people – 52 per cent – were aware of social issues and said those things were more important to them.”

BetaShares chief executive Alex Vynokur also believes that while the environment has been a first consideration, investors have been given prompts to consider other issues with the passing of modern slavery legislation in many countries and the Hayne royal commission putting a spotlight on governance issues, while the Me Too and Black Lives Matter movements have elevated social issues.

As a result of this, Vynokur says the inflow of money into investment products that are broadly ESG focused, as well as those addressing specific issues, is starting to climb at significant rates. For example, inflows into ethical exchange-traded funds (ETF) increased by 145 per cent in 2021, and of the 400,000 SMSFs that hold an ETF, 30 per cent have some form of ESG investment, according to BetaShares data.

“If we just focus on the environment and addressing climate change, that will require the mobilisation of billions of dollars in capital and a lot of technological innovation, which creates significant demand for various investment opportunities,” Vynokur says.

This interest is being reflected in the concerns of investors as well, according to Ethical Investment Services chief executive Michelle Brisbane, who says environmental concerns are the main issue for clients, with an expectation the other issues will also be considered.

“We see the E component as the leading theme for clients coming to see us and the social factor is a concern for some clients, while the governance factor is something we monitor as part of our research. Clients do not usually have issues with the governance, but expect our research addresses this for all our approved investment recommendations,” Brisbane explains.

There is also an alternative social driver for some clients, HLB Mann Judd Wollongong partner and superannuation specialist Mitchell Markwick says, which is bringing people to ESG investments. “There is a social factor, a social pressure, when people are looking to invest in environmentally appropriate-style investments. It is at the forefront of a lot of people’s minds and they are looking at the ESG parts of an investment because there is a bit of social pressure to do so,” Markwick suggests.

“This means there can be a lot of talk about it, because the social factor makes it the right thing to do, but at present I don’t think ESG investing is as widespread as it could be and we have probably around 5 per cent of clients that have a portfolio built around ESG investing.”

Loose definitions

These new opportunities for investing have led to the rise of ‘greenwashing’ where companies seeking ESG investment inflows present a more ethical and socially conscious way of doing business than is actually true.

Testing those claims may be possible, but it can be a time-consuming task for financial advisers and SMSF trustees who have to understand the terminology in use when discussing ESG and how companies are applying it.

The problem is there is no standard set of definitions being used in Australia, Zenith Investment Partners head of responsible investments Dugald Higgins points out, which in turn impacts the ability of funds management firms to offer products to investors.

“ESG definitions are a hotly debated topic and everywhere around the world there are calls for it to happen but nobody knows how to do it,” Higgins observes.

“What we have seen in Europe is they have had a crack at this and tried to create a system that classifies companies as ‘green’ or ‘brown’, which has become known as the European taxonomy, but it is not perfect.

“Once there is a framework which everybody agrees to, we can take the next step with a fund that is investing sustainably and look at that fund and monitor its holdings against the taxonomy to see what it is doing and how well it matches the framework.”

Ashton says because ESG investing is still in its infancy and there is a lack of set definitions for it, in many cases what constitutes ESG is determined by the views of investment managers, advisers and their clients.

“Do you invest into a company that fares poorly on ESG now, but is really committed to improving? Some people will not invest in iron ore producer Fortescue even though it has stated it wants to produce ‘green’ iron by 2025. So, do you invest now because it has committed to greening their industry?” she asks.

“There is a lot of that kind of thing going on where something is green in the eyes of the beholder because there are no ‘accepted’ frameworks.

“There are frameworks, such as the United Nations Principles for Responsible Investment (UNPRI), and those produced by the Responsible Investment Association Australasia (RIAA), but people don’t really use them.”

Reilly suggests advisers faced with this wealth of information but without defined parameters should consider questions of transparency and ask for evidence of ESG processes.

“How a fund manager creates a sustainable approach to handle ESG is not always going to be in the fund name and there are companies and fund managers who simply hide behind being a signatory to the UNPRI,” she says.

“We highlight the importance for advisers to ask for evidence of how is a fund manager, or a company, taking into account ESG risks and opportunities in their business model and in their investment process.

“They also need to report on what they have done during this time of debate about what a robust investment process looks like. If the evidence is there that a manager does not walk the walk, there’s a high risk of losing business and we have seen managers with these ineffective policies and processes being left behind as capital moves out towards those who can do it.”

Not an asset class

Marshalling all this information into a useful resource and set of knowledge to assist clients is vital, according to Higgins, who feels it is important advisers understand ESG investing is more than a broad-brush approach covering everything when assisting clients to create a portfolio. “ESG investing is about managing assets while incorporating environmental, social and governance factors into investment decisions and being able to identify and evaluate ESG risks and opportunities,” he says.

“While all these approaches can take into account non-financial considerations, they are subtly different. I would argue that all investment strategies can have ESG elements applied to a greater or lesser extent as it complements traditional financial analysis and portfolio construction techniques.

“The same cannot be said for pure ethical and sustainability-focused investing, which tends to meaningfully change the objective and shape of a portfolio’s holdings.”

For SMSF practitioners used to covering more complex and technical issues for clients, providing advice around ESG investing will also require an individual approach aligned to the specific values each client brings to the table, according to Brisbane.

“Part of an SMSF’s stated investment strategy will include ‘the fund wishes to apply ethical or ESG screens to the investment choices’ and this can be accomplished by considering a client’s values and how they can be best aligned with their investments,” she says.

“Companies that focus on and manage their ESG factors are better managing the resource efficiency of their businesses, and therefore it can be argued there is a greater opportunity for longer-term outperformance compared to those not managing ESG factors.

“Not paying attention to ESG also increases the risk of a business and it is more prone to share price shocks if found to have deficiencies in its ESG approach. For example, garment manufacturers not addressing modern slavery and found out to have this as an issue in their supply chains.”

In their interactions with advisers, Ashton and Higgins are seeing two broad patterns emerging in how advisers are approaching ESG investments and, unsurprisingly, in some cases it is not too different from any other niche investment approach.

“Some people are using it as a satellite approach where they are using very green funds with a strong impact investing approach around a core of Australian equities. There is not a lot of those type of funds around and they tend to be expensive, but there are people ready to use those sorts of investments,” Ashton says.

“The other approach is people who are more worried about the planet overall, for example, and thinking about the legacy they leave.”

Higgins adds for this group, while there is no universal standard for assigning ESG factors, there are strategies available for advisers to pull together.

“For some advisers, that may be working with a direct equities portfolio and simply applying a negative screen on the traditional ‘sin sectors’,” he says.

“For others, they may wish to create a portfolio of managed funds with strong, complementary aspects regarding sustainability to create a portfolio that seeks to minimise harm and maximise a progressive transition on key issues. However, given the variation of client requirements, mass customisation of approaches is difficult.”

Values versus performance

And what is the cost to the investor for delving into ESG? Aside from the advice and investment management fees, does ESG leave performance on the table while saving the planet? Brisbane and Vynokur believe this is not the case.

“Clients want good returns from investments that meet their ethical criteria and RIAA research over the long term indicates that returns are either as good as or better than mainstream counterparts,” Brisbane notes.

“As such, the common requests we receive from clients are to review existing portfolios to realign them with their values and divest other investments.”

Vynokur recognises the issue of performance may have been an issue in the past, but indicates this is no longer the case as evidenced by several different industry trends.

“When we started BetaShares in 2010 the conventional wisdom at the time was you have to sacrifice performance for values, but over the past decade investors have understood that is not the case and this has brought more investors to adopt sustainable investing as the core,” he says. “If you look at just the sheer weight of dollars coming into ESG products, from an industry perspective, there is a significant rise in the rate of adoption. But we are also seeing a trend by regulators actually informing superannuation trustees they are not doing their job if they fail to consider ESG risks in portfolios.”

But does the same apply for SMSFs and are there problems if a fund goes all in on ESG investing in the same way some have significant exposures to property?

“There should not be any regulatory problems with ESG or ethical investing as it just is an overlay for an investment portfolio,” Brisbane says.

“The ESG aspects are addressed across the entire portfolio and each asset class and ESG is not an asset class. Rather, we see ESG becoming a first-pass filter for investors to look at before they begin to formally evaluate an investment as they do today in the areas of performance, financials and strategy management.

“As mentioned, research by the RIAA indicates no loss of financial performance by applying an ESG filter and academic research supports a better return per unit of risk – Sharpe ratio – for ethical investment portfolios. So, we see aligning members’ ethical values with the investment portfolio as in keeping with the sole purpose test.” Markwick concurs with Brisbane but adds, as in the case of investing in property, ESG investing needs to be reflected in the investment strategy.

“I doubt we will ever see the ATO state that since an SMSF invested in some form of ESG product and it did not produce a return similar to a normal investment that it will be penalised,” he predicts.

“I don’t see that happening, but from my perspective I would like a reference to an allocation in the investment strategy to an ESG-style investment where the trustees acknowledge they are allocating a particular amount of the fund to that sort of style investment.”

More work to do

Given the current trajectory of societal interest and availability of ESG investments, it would appear this market will continue to grow, creating new homework for advisers.

“Appetite for ESG consideration is growing across all demographics. Investors are starting to realise, and returns are proving, ESG investing can provide a safer portfolio, with solid returns, as well as the knowledge that your money is working towards better world outcomes. There is an increased interest in impact investments and SMSFs are ideal vehicles to hold these assets in a super environment,” Brisbane says.

And Ashton suggests this is where the homework begins, but with varying approaches.

“Some advisers are on the front foot when it comes to ESG, while others are being led by their clients, but in many cases they still remain unsure how a conversation on this topic will go. They don’t know the topic well enough and therefore don’t know what say to a client when it comes to ESG,” she says.

“While there are still a number of curly questions to be answered, advisers who get in on it early will lead in this area and they are already definitely starting to write more business and see more funds flow.”