The last couple of years have seen a surge in global and local events that have transformed environmental, social, and governance (ESG) investing from being focused solely on social issues, to having material impact on investment performance.
The investment industry has been shifting towards responsible investing since its inception in 2006 and over the past decade, sustainable strategies have shown both strong assets under management (AUM) growth and positive asset flows. Globally, ESG funds recorded the highest flows last year and by 2025, ESG investing is projected to reach $53 trillion in assets. This equates to roughly a third of all investment assets under management.
A catalyst for ESG investing, the COVID-19 pandemic increased awarenessthat as humans, we are not necessarily living in harmony with our planet and that we can survive with less in many aspects, particularly air travel. The extent to which pollution levels dropped during the various lockdown periods also highlighted the need for change in human behaviour. Stocks with better ESG ratings fell but still outperformed their respective benchmarks between February 2020 and April 2020 as the virus spread across the globe. Inflows into ESG products increased with the launch of new funds as well as the repurposing of non-ESG funds.
Locally, the increased reporting of governance failures in a number of entities, for example, Abil, Fidentia, Lonmin, First Strut, Steinhoff, VBS, Aspen, EOH and Tongaat Hulett among others, has meant that the inclusion of ESG factors into the investment process should not be seen as a tick box exercise or as value destructive. Rather, this should be a step towards doing the ‘right thing’ and achieving superior long-term investment returns with no compromise on returns. In these instances, we observed that funds that were exposed to these shares paid the price in performance and the reputations of their managers.
Recently, we have seen an evolution of the investment process from a two-dimensional approach (risk and return) to a three-dimensional approach (risk, return and impact). In other words, the efficient frontier is no longer a two-dimensional process.
What are ESG factors?
ESG investing refers to assets that are selected according to their Environmental, Social, and Governance factors. These factors are incorporated into the investment process and can fall into four main categories:
- Values and screening: Inclusion or exclusion of sectors, companies from investments.
- Integration: A companies ESG factors.
- Thematic: Focuses on ESG themes.
- Impact: Specific ESG goals are designed to be met.
These ESG factors highlighted above can be used alongside traditional financial metrics to rate companies. The most common ways to invest responsibly have been through either ‘exclusion’ or ‘integration’.
What are the key drivers behind ESG investing?
- Materiality: ESG factors can affect risk and return. Therefore, the incorporation of ESG factors within the investment process may improve investment results.
- Market demand: Increased demand from both investors and asset owners on incorporating ESG factors into the investment process and having their investments reflect their personal values.
- Regulation: Regulators requesting that ESG be considered as an investor’s fiduciary duty.
- Data: Richer and relevant data.
The above clearly illustrate that incorporating ESG factors into the investment process should be at the core of any investment manager.
How do Multi Managers apply ESG to portfolios?
As a Multi Manager (MM), a scoring process is followed to assess how each asset manager incorporates the ESG factors into their investment process, strategy and mandate requirements. Thereafter, the actions taken by the asset manager as a result of their ESG compliance are monitored. The incorporation of ESG funds together with non-ESG funds enables a MM to diversify their portfolios.
Many asset managers have begun integrating ESG factors into their investment process. These factors can affect economic growth and can inform the geographic and sectoral diversification as well as the long-term strategic asset allocation. In South Africa (SA) it is difficult to exclude SA stocks on ESG grounds as the universe of stocks to select from is relatively small. Most of SA’s debt is linked to the state-owned power utility Eskom. Furthermore, electricity consumed in SA is primarily produced by coal burning power stations. As a result, it is easier for European investors to avoid investing in certain sectors than it is for SA only investors.
ESG has been thrown into the limelight and investors are seeing both the financial and social imperative for sustainable investing. It continues to transform economies and will soon become second nature to investors. It is impacting multiple industries across the globe and opportunities lie within those sectors that are going to benefit from the transformation to green energy, electric vehicles and battery technology, such as Tesla. However, risks lie in sectors that are going to be on the wrong side of this transformation, for example oil companies.
From a fixed income perspective there has also been a rapid growth of green bonds that are designed to raise funds for the climate or environmental projects. These bonds are generally issued by governments, corporations, and financial institutions.
It is envisaged that as ESG becomes more embedded, asset managers will move away from shares and bonds in companies that have not made commitments to become carbon neutral. Eventually sustainable investing will simply be considered ‘investing’.