Ethical investing can harness the power of money to deliver competitive returns – as well as positive change for society and the environment.
Responsible investing is rapidly moving into the mainstream of professional funds management. It is often referred to as ethical investing, sustainable investing or Environmental, Social and Governance (ESG) investing. While the sector encompasses a wide range of strategies, there are some core investment beliefs all responsible investors share. The Principles for Responsible Investment (PRI) begin by stating professional investors “have a duty to act in the best long-term interests of their beneficiaries”.
Signatories to the PRI also agree that “environmental, social, and corporate governance (ESG) issues can affect the performance of investment portfolios”. PRI signatories promise to integrate issues like these into their investment approach and decision making. This process, known as ESG integration, is the predominant approach taken by responsible investors.
Getting the process right
ESG integration is an extra layer of risk mitigation included in the investment process alongside more traditional financial risk measures. This process might lead to an assessment that ESG risks are appropriately priced in, resulting in no adjustment to a portfolio. Listed companies are now deploying big budgets to develop Sustainability Reports that ensure ESG risks are being identified and adequately managed, thereby earning a tick of approval from ESG managers. This is different from investment processes that adopt a more “values-based” approach, which is more suited to investors who are genuinely concerned about the impact of their investments.
Investors like Australian Ethical go further than ESG integration by screening out investments that breach an ethical principle – for example, we do not invest in fossil-fuel companies, nuclear energy or tobacco. Investors who include this type of negative screening in their process tend to be labelled “ethical”. However, we exceed even this definition because every investment we make must have a positive impact on the planet, people or animals.
Busting myths about performance
The 2020 edition of the RIAA benchmark report reaffirmed that responsibly managed funds outperform mainstream funds over most time frames and asset classes. It further erodes the myth that responsible investors must sacrifice returns because they limit their investable universe. Instead, the evidence suggests screening out ESG risks leads to more resilient portfolios of well-governed, sustainable companies. In addition to the RIAA research, Australian Ethical’s performance is good evidence that ethical screening does not reduce returns.
Our Australian Shares Fund (wholesale) has returned 14.0% per annum since its inception in 1994, outperforming its benchmark by 4.8% per annum to 31 August 2020 (i). What’s more, this performance has been achieved with a lower level of risk than the median Australian equity fund (ii).
Staying ahead of the (risk) curve
Conducting research on ESG issues, or in our case on ethical issues, can help responsible investors identify risks and opportunities earlier than investors who do not conduct the same level of research. For example, responsible investors consider factors such as human rights abuses in supply chains or regulatory risks facing tobacco, alcohol or fast-food companies. These are issues that can hit both the reputation and bottom line of a company, but they often get missed by investment managers who ignore ESG issues.
At Australian Ethical, we rigorously apply our ethical frameworks to define a universe of investable companies that is skewed to more “forward looking” sectors with good investment characteristics and exposed to significant trends such as the ageing demographics, the exploding demand for data or the need to combat climate change. We believe this approach enables us to build portfolios that will lead to superior risk-adjusted returns.
Advocating for change
Investors have influence as owners of companies, and they’re starting to use it. BlackRock CEO Larry Fink makes company executives sit up and pay attention when he demands they take issues like sustainability and climate risk seriously.
With more than US$7 trillion in assets under management, BlackRock wields substantial voting power at company AGMs. Australian Ethical is also a vocal advocate on ethical issues, having engaged with over 400 companies in the past year on behalf of the planet, people and animals to drive positive change.
Making an impact
Impact investing is closely linked to responsible investment but tends to be misunderstood. According to Impact Investing Australia, impact investments are “investments made into organisations, projects or funds with the intention of generating measurable social and environmental outcomes, alongside a financial return (iii)”.
The key point is that the selection process must include intentionality and the impact must be measurable – and that’s something the responsible investment sector continues to grapple with. For our part, we have our share portfolios independently assessed to gauge their carbon emissions versus the fund’s benchmark index. At 31 December 2019, our portfolios produced emissions that were 75% lower than the benchmark (iv).
We also measure our impact against the United Nations Sustainable Development Goals (SDGs), as assured by our auditor, KPMG. This year’s analysis found our investments had 3.5 times more impact to achieve the SDGs than the benchmark, and five times more investment in renewable power generation than the global sharemarket.
This article first appreared in the ASX Investor Update newsletter.
[i] To 31 August 2020. Benchmark is composite S&P/ASX Small Industrials Accum Index up until 12 August 2019 and S&P/ASX 300 Accum Index thereafter.
[ii] Morningstar scatterplot chart of peers over the 10 years to 30 June 2020 (slide 28).
[iii] Impact Investing Australia website https://impactinvestingaustralia.com/new-impact-investing/
[iv] The benchmark is a blended benchmark of the S&P ASX 200 Index (for Australian and New Zealand share holdings) and MSCI World ex Australia Index (for international fund share holdings).