26 February 2019
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. It is time to reaffirm our commitment.
Active portfolio managers normally have a clear brief and a fiduciary responsibility which boils down to delivering the best risk-adjusted returns they can to 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.
Not real impediments
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 the ability to diversify a portfolio.
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.
We could point, for example, to a Chinese renewable power company that floated on the Hong Kong market in 2011. It was expensively valued but promised great growth and excited some ESG observers (more than the fund managers) at the time. It has delivered the promised growth in revenues but at a huge cost in terms of balance sheet debt. The shares more than halved in the first year or so of trading and still have not recovered to their initial price. This is just one case that nicely illustrates that an investment approach that just focuses on ESG criteria and excludes traditional investment considerations is at best risky and at worst irresponsible.
Lower cost of capital
So where does that leave us? Are we deliberately forgetting valuable investment principles when we embrace ESG considerations? Actually, no - 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. (And, by the way, that also means that companies that are on a clearly improving trajectory could stand to benefit most, so we should not ignore the prodigals.)
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 - it was essentially a contingent future liability. 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.
ESG best practice as a basic statement of principle
If in the past we saw global governments as steadily advancing a constructive position of encouraging universal adoption of best practice in order to enhance social goods and the global environment, are we now seeing them giving up on this goal - to one of unilateral withdrawal from these objectives in the hope of gaining cost and competitiveness advantages?
This is a big question and one that sadly fund managers are not especially well qualified to address. But it is a concern and certainly challenges the notion - which was surely rational to hold in the past - that adopting ESG principles in investment was compatible with, and might even have enhanced, the investors traditional risk and return objectives.
Nevertheless, 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 as a means to achieve one’s investment objectives, but separately and in parallel to them.
In a world where active managers have to prove that they are custodians of the interests of their clients - even if the governments who are meant to represent their citizens' collective long-term interest may appear to be failing to do so - as corporate investors responsible for looking after large amounts of client money and also for collectively setting the cost of capital for companies around the world, we must maintain the highest possible standards. We also need to enhance our engagement with companies to share these views with them.
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 our 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. Past performance is not a reliable indicator of future results.
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