Responsible Investing Part Two: implications for everyone in financial markets

Monday, March 27th 2017, 6:01AM

by Pathfinder Asset Management

The essence of responsible investing (RI) is not its focus on environmental, social and governance issues (ESG) – these get the headlines but are about implementation.  The essence of RI is simply to change investor and corporate horizons from the short-term to the long-term.  RI is about shifting the focus from maximising near term returns to generating long-term sustainable returns. 

A long-term focus means that the investment process considers risks expected to impact many years ahead, not simply many months ahead.  Seen through this lens “responsible investment” is the same as “conventional investment” – it is about generating value and cash creation (but includes a wider range of longer term factors). 

What does a trend to responsible investing mean for participants in financial markets?  Below we consider the perspective of companies seeking capital, investors, fund managers, financial advisers, regulators and the government.  There are implications for everyone.

Companies that seek public market capital

For many companies RI may initially mean shifting the focus of corporate reporting and communication.  Rather than simply reporting on profit for the last financial year, increase reporting on environmental, social and governance issues as well.  Rather than focusing on current operations and near term performance, clearly articulate the long term corporate strategy and goals.  A change in reporting and communication to include ESG factors will drive a change in the way a corporate operates, including a longer term view on its capital investment.   

A recent McKinsey survey looked at 600 firms and whether they invested with a short-term or long-term view.  They scored companies for bad habits of “short-termism” – including investing relatively little, cutting costs to boost margins and initiating lots of share buy-backs.  Their study concluded that 73% of the firms were currently “short-termist.”¹  As awareness of RI increases, this will change.

Investors

ESG integration adds an extra dimension to conventional stock analysis.  Company earnings and value are not only driven by tangible factors (such as the value of factories, plant, stock on hand and cash in the bank), but also by a wide range of intangibles.  The most widely understood intangible is brand value, being goodwill and reputation.  This in turn is made up of a host of difficult to value, but very real, drivers such as corporate culture, relationship with suppliers and management of environmental risks.  Getting any of these wrong impacts company profits and ultimately the company’s share price. 

Active investors must stay alert for companies that do not properly price the cost of doing business.  Ignoring very real costs can point to a long-term valuation issue.  For example, is current year profit overstated because the company can pollute without paying for the cost of clean-up?  Is production and labour being moved to extremely low wage companies but the cost saving may not be sustainable or the company’s brand may be tarnished in the eyes of developed world consumers?  These are ESG factors that matter for the long-term value and viability of a business.  ESG analysis is a highly technical area that may be embedded in a research process by outsourcing to global ESG specialists such as Sustainalytics.

Fund managers

As investors, fund managers are part of the trend towards including ESG factors in the investment process.  Managers can also sharpen their process for structuring fund products and communicating with investors (next month we will look at how the UNPRI and RIAA product certification apply here).  A common area for fund managers to implement RI principles is to become more active as an asset owner.  This means using shareholder rights to engage the company and encourage change.

The alignment of fund manager incentives may also come under the microscope.  If a fund manager truly changes its time horizon from short-term to longer term, should this be reflected in how performance fees are structured?  In particular is a 6 month or one year time horizon for calculating performance fees appropriate if the manager’s intent is to generate long-term sustainable returns for investors?

Financial advisers

It is not the role of a financial adviser to agitate for social change.  However advisers do have responsibilities to understand their client’s needs, to promote their client’s interests and to explain features of product offered.  Here’s how RI fits in the current Code of Conduct for financial advisers:

  1. Client interests first under Code Standard 1 -   An investment adviser’s role is to balance financial risks and returns so the client may meet their goals. In doing this they must “place the interests of the client first.” Placing client interests first means you need to know what your client interests are – for example is assessing ESG risks or investing ethically important to the client?  As an adviser, how do you know it’s important if you don’t ask?
  2. Informed client decisions under Code Standard 7 – “An Authorised Financial Adviser must ensure each retail client has sufficient information to enable the client to make an informed decision…..”  To do this the adviser should make the client aware of RI features (or shortcomings) with product offered – otherwise is there sufficient information for the client to make an informed decision?

Financial market regulators

Regulators are concerned with risk, particularly where risk may impact on the financial system. For this reason it is no surprise that regulators offshore have started emphasising ESG issues. 

The Australian financial regulator (APRA), which regulates the parents of many NZ banks, believes climate change may be a long-term threat to the financial system².  APRA are concerned that “some climate risks are distinctly “financial” in nature. Many of these risks are “foreseeable, material and actionable now.” According to APRA, ESG risks matter. 

In 2015 the Bank of England govenor (Mark Carney) described climate change as “the tragedy on the horizon” and one of many “emerging, mega risks”.  The Bank of England’s concern is that climate change may have “profound implications for insurers, financial stability and the economy.”³

Carney notes that there have been some “high profile examples of jump-to-distress pricing” through environmental issues (i.e. ESG risks may not manifest in a slowly declining share price, but rather a sharp and sudden adjustment).  He believes that regulators should consider these risks and how they impact business models of financial institutions.  Even if as an investor you do not believe that ESG considerations are relevant to your portfolio, they do in fact matter when the regulator says it matters (regulator actions will impact your investments).

Government

There’s obviously a great deal that government can do to regulate ESG matters – examples include employment practices, water quality, emissions controls, minimum wage levels and the storage of hazardous materials.  But there are also unexpected areas where government can focus to enhance responsible investment, examples include:

Governments will stay involved in regulating ESG risks – which of course presents both risks and opportunities for investors.

Summing up

Responsible investment is more than a fad or a fringe activity.  It will increasingly impact everyone involved in financial markets.  More companies will modify their reporting to include ESG factors which in turn will change the way they operate.  Fund managers and investors may choose to build ESG factors into investment analysis and then engage more with the companies they invest in.  More financial advisers will make sure they understand how their clients view ESG matters before making recommendations.  Regulators will stress test for ESG risks and their impacts on the financial system.  Governments will continue to legislate on ESG matters which will mean costs and risks for business and the wider economy.

RI is about adopting a long-term investment horizon yet short-term securities trading remains at high levels.  For companies in the S&P500 index, each share changes hands on average every 200 days (4).  Short term asset owners don’t typically include ESG issues in their investment process, yet increasingly ESG matters. 

A greater emphasis on ESG issues will mean more financial markets participants switch from chasing short-term returns to seeking long-term sustainable returns.  Stretching out the investment horizon is the foundation of responsible investing.


John Berry is a founder of Pathfinder Asset Management Limited and is an independent director of Punakaiki Fund Limited. This commentary is not personalised investment advice - seek investment advice from an Authorised Financial Adviser before making investment decisions.  Disclosure of interest: Sustainalytics has been engaged by Pathfinder to provide independent ESG screening for the Pathfinder Global Water Fund (a responsible investment fund).


Notes:
¹  The Economist, 18 February 2017 page 58.
²  http://www.apra.gov.au/Speeches/Pages/Australias-new-horizon.aspx
³  www.bankofengland.co.uk/publications/Pages/speeches/2015/844.aspx
4 The Economist, 18 February 2017 page 58. Note that high frequency automated trading is a significant influence on this number.

Pathfinder is an independent boutique fund manager based in Auckland. We value transparency, social responsibility and aligning interests with our investors. We are also advocates of reducing the complexity of investment products for NZ investors. www.pfam.co.nz

Tags: Pathfinder Asset Management responsible investing

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