By Joel Connell, Senior Global Equities Analyst at Bell Asset Management
The importance of integrating ESG related risks and opportunities into investment decisions has become undeniable. The ability for companies to generate superior shareholder returns is increasingly intertwined with ESG and sustainability factors.
Consumers are increasingly voting with their feet and making purchase decisions that take into account a whole host of ethical and sustainable considerations, in addition to the price and quality of a product or service. For some, that may include basing decisions on simple considerations like the ingredients that are contained within a product, while others seek a deeper understanding of a company’s supply chain and operations, and will only buy products or services from those companies that are reducing their environmental impact or taking measures to ensure the safety and well-being of workers within their supply chains.
Companies that focus attention on ESG factors also often have happier and more productive employees, and this has never been more important than over the past 18 months where the COVID-19 pandemic has upended the way that a large portion of the global population live and work. Appropriately addressing ESG issues can also mitigate the risk of negative regulatory actions or litigation. Ultimately, companies that do a good job managing ESG risks, or are well positioned to benefit from various sustainability tailwinds, will be in a stronger position to deliver superior financial outcomes over the long term.
We also continue to see a massive flow of assets being directed to ESG or Responsible Investment strategies. According to Responsible Investment Association Australasia (RIAA), the Responsible Investment AUM in Australasia increased by 30% in 2020 to $1.28 trillion, constituting 40% of total managed fund AUM, up from 31% in 2019. At the same time, the AUM for the remainder of the market decreased 11% to $1.92 trillion.¹ The positive ESG flow trends are likely to continue, with research from Bloomberg Intelligence (based on data from the Global Sustainable Investment Association) forecasting that global ESG assets are on track to exceed US$50 trillion by 2025, up from US$23 trillion in 2016 and US$35 trillion in 2020.² This flow of assets is enabling companies with strong ESG credentials to attract more capital and often premium valuations relative to companies with poor ESG credentials.
This paper takes a look at some of the key factors that investors should consider when allocating funds to an ESG strategy, highlighting the key advantages of active strategies. Of course, there are many additional considerations that investors should take into account, including management costs, performance objectives, and whether the investment philosophy and approach adopted by a fund aligns with their own personal philosophy around ESG/sustainable investing.
As an active manager, we (Bell Asset Management) admittedly have a clear bias in the active versus passive debate, but we believe the advantages of an active approach when it comes to ESG are very clear relative to passive investing.
Below we outline five key reasons why investors should consider adopting an active versus passive approach when it comes to ESG:
Investing is complex and always requires a large degree of subjective analysis. The level of complexity is arguably even more elevated when it comes to incorporating ESG related factors into the portfolio construction process.
Some aspects can be easily integrated, such as exclusion screening where certain stocks or sectors with undesirable characteristics are omitted via a simple screen (i.e. Tobacco), or a portfolio could be constructed based on a narrow set of metrics such as the underlying level of greenhouse gas emissions or the ESG rating assigned by a third-party research provider. However, the complexity and wide-reaching nature of many ESG issues means that fully integrating ESG risks and opportunities into investment decision making is a difficult task, especially for rule based passive funds.
In our view, investors should take a holistic approach and use a combination of different steps including exclusion screening, active engagement, shareholder/proxy voting and thorough fundamental analysis to achieve favourable ESG outcomes. There is often no easy way to distinguish between a ‘good’ or ‘bad’ company from an ESG perspective and measuring many of the different inputs is fraught with challenges. For example, while some ESG issues such as specific fines against a company or the impact of a mandated wage increase may be measured financially, much of the analysis is subjective and outcomes can differ greatly depending on the materiality of an issue, as well as the industry or company being assessed. This makes it particularly difficult for passive funds to construct portfolios that are able to generate positive outcomes across a broad range of sustainability factors.
The importance of different aspects of ESG can also change over time, thus making a more static passive approach less able to adapt to changing conditions. For example, since the onset of the COVID-19 pandemic we would argue that many Social risk factors such as employee & customer safety and supply chain labour standards have become ever more important considerations. Additionally, the regulatory environment is constantly evolving across various topics such as data privacy and environmental targets. This means the impact that ESG issues can have on the investment case of a company can change over time. Active managers with a strong ESG framework and experienced investment team are far better placed to adapt and evolve their decision making to address any such changes.
As noted above, passive ESG funds are often constructed based on a small number of easily quantifiable metrics. This means that it can be difficult for a passive strategy to deliver positive outcomes across the ESG spectrum. For example, a ‘low carbon’ passive strategy may well achieve its desired objective of being more environmentally friendly than other strategies but then may rank poorly when it comes to Social related outcomes such as product safety or Governance outcomes such as board diversity.
Active managers that engage a more comprehensive approach to investing, can better encapsulate the wide range of inputs to construct a portfolio that is better positioned to avoid unnecessary risks and deliver superior overall ESG outcomes. In particular, active managers are better positioned to take a forward-looking view and identify companies that are improving their ESG practices and contribution to society. This is in contrast to passive strategies which typically rely on historical data. For example, it may be easy for a passive strategy to screen for companies with low carbon intensity at a single point in time but active strategies managed by experienced and pragmatic investors have a discernible advantage in that they are better positioned to identify companies that have strategies and targets in place to continue reducing their environmental footprint over time.
Passive ESG or sustainability funds are often designed or constructed in a way that does not directly consider the expected investment returns or any valuation factors. While the underlying premise behind many ESG strategies is that sustainable investing will help to deliver superior investment returns, in addition to better ESG outcomes, there is often little to no regard given to many of the forward-looking company fundamental factors that drive returns over the long term. As an example, any passive ETF which tracks the MSCI World ESG Leaders Index would be constructed based on the underlying holdings of this index, where companies are selected on the basis of their MSCI ESG rating, along with exclusions of companies that are involved in serious controversies or controversial industries such as alcohol, gambling, tobacco and weapons (among others). There is absolutely no regard given to important metrics such as financial leverage or profitability, or forward-looking considerations such as valuation or expected growth in cash flow and earnings.
At Bell Asset Management we firmly believe that ESG and Sustainability factors are crucial to helping companies deliver superior long-term shareholder returns, but equally as important are factors such as profitability, franchise strength, financial strength, quality of management, broader macro business drivers and the price you pay (i.e. valuation).
We would argue that active fund managers are much better positioned to construct portfolios that can achieve both superior ESG outcomes and superior investment returns. There is no reason why investors should have to sacrifice one for the other. For example, the Bell Global Emerging Companies Fund, which is invested in global small and mid-cap equities, has achieved a 5 globe Sustainability Rating from Morningstar and is ranked in the top 1% of its category (Equity World Mid / Small) with respect to Sustainability. In addition to the excellent Sustainability outcomes, this Fund has also delivered a net return of 17.6% per annum over the five years to 31 October 2021, ranking number one its category for performance according to Morningstar,³ thus demonstrating that it is possible to achieve both positive ESG outcomes and strong performance outcomes.
One of the most important differentiators between active and passive investing when it comes to ESG is the ability of active managers to engage with corporate management teams to drive positive change. To be fair, some passive fund managers do actively engage with companies and can also use their scale to have an influence, particularly with respect to proxy voting decisions. However, their influence is often diluted by the fact that stock holdings and position sizes within their funds are typically set by the underlying index which they are tracking, rather than any active decision about whether to change the weighting or divest a position.
Active managers, on the other hand, have the ability to use their engagement with corporate management teams to drive real change. If a company is not appropriately addressing a significant ESG related risk then engagements can be escalated, and if outcomes are not satisfactory, then an active decision can be made to avoid investing in that company or divest the position if already held in the portfolio, thus starving poor ESG performers of capital.
We believe that active engagement is crucial to properly understanding ESG risk factors and driving improvement in all facets of ESG. This includes direct engagement with corporate management teams, effective use of shareholder/proxy voting, and participation in industry collaborations. We have witnessed significant improvements in the actions of many corporates in recent years which we believe is partly an outcome of many active fund managers stepping up their levels of engagement on ESG related topics. There is still a lot of work to be done but we firmly believe that the company engagement from active fund managers will be critical to driving further improvements.
Investors in passive investment strategies typically have no way of engaging with their fund manager. If a stock underperforms or an ESG controversy arises, they cannot simply pick up the phone and ask why. Educating investors and responding to client queries is a crucial role of active fund managers and is particularly important when it comes to the topic of ESG, as many issues are not black and white. All companies face ESG related risks and therefore being able to understand why certain decisions have been made or gaining insight into discussions that a fund manager is having with corporate management teams is incredibly important.
In addition, we believe that conversations we have had with many of our clients, advisor partners and asset consultants over the years have helped to improve and refine our understanding of what matters the most when it comes to integrating ESG factors into our investment approach. Passive investing simply does not come with the same client engagement benefits for investors.
While passive funds will always have a role to play in the investment landscape for certain investors who prefer lower cost or simple to implement diversified investment options, we firmly believe that when it comes to sustainability and the integration of ESG related factors, that active management has clear advantages over passive.
Active managers with an experienced investment team who adopt an investment philosophy and process which fully integrates ESG risks and opportunities should be well placed to deliver both superior ESG outcomes and superior investment returns.
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