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Getting to grips with responsible investing

Responsible investment is the topic du jour in the global investment world. Unfortunately, in New Zealand, the focus is largely on only one part - “Negative” exclusions.

Tuesday, August 14th 2018, 6:00AM 6 Comments

by Pathfinder Asset Management

This involves removing companies in a portfolio that are involved in egregious industries, for example, controversial weapons, gambling, tobacco and thermal coal.

This is a good first step but it's not enough. Going beyond exclusions, investors can use current controversies and Environmental, Social and Governance (ESG) scores (positive factors) to better understand future non-financial risks.

Research says using ESG works. A 2016 report by Bank of America Merrill Lynch found that investing only in the above average ESG scoring companies helped avoid 15 of 17 bankruptcies in their US stock universe, since 2008. While we’re not talking bankruptcy, Facebook is another real-world example of ESG scores helping to understand a business.

The Facebook example

Facebook has had a howler of an earnings season. A 42% growth rate in revenue would be a miracle for most companies but for Facebook, a high growth company with temperamental shareholders, it is the first guidance miss since 2015. Daily and monthly user numbers are also slowing, whilst its cost of business is expected to increase faster than revenue this year and into 2019.

After two years of negative headlines, data breaches and election meddling, shareholders had finally had enough. Facebook’s share price reacted to this negative news flow in late July – losing 18% in a single day. Losing US$120 billion is a lot, that’s more than the total market capitalisation of New Zealand.

Facebook has been unbelievably successful leading up to this point. But, the company is now starting to pay for years of a grow-at-all-costs mantra.

Learning from BP’s disaster

Using an ESG scoring framework can provide insights into future financial costs for a company due to some incident or wrongdoing. Take the BP Deepwater Horizon oil spill as an example – an environmental impact that cost the company billions from not having proper checks and balances in their environmental policy.

Facebook is in a similar position.  It has long had a poor governance rating, its governance score is one of the lowest of US-listed large-cap companies.

Understanding its poor governance model and the very vocal gung-ho growth message from management, an analyst looking at more than just financial data may have been a little more pessimistic about the future of Facebook.

And they should have, the company now needs to hire an additional 20,000 staff to deal with data security and political meddling. Facebook’s CFO, David Wehner, told investors the company is “making significant long-term investments” in safety and security.

And that “those investments are in the billions of dollars per year; those will have a negative impact on margins”. How much? Almost a 10-percentage point decrease in margins from costs that could grow by 50-60%, into 2019. Grow-at-all-cost now has a cost.

Why ESG?

Avoiding these future financial risks is where responsible investing can not just do good (in terms of ethics) but add real financial value to a long-term investor. Poor ESG scores are a long-term indicator – they won’t tell you if a share price disaster is happening in the next week.  But the share price impact from a serious ESG event can be as big as a company reporting a massive earnings collapse. As responsible investment evolves and becomes mainstream, the impact of these non-financial risk factors becomes more visible. 

Negative screening takes away “bad” companies in “bad” industries.  A fully integrated ESG policy takes away the “bad” companies in “good” industries.  Responsible investment (through the assessment of non-financial factors) can add real value for investors.

 

Karl Geal-Otter is an investment analyst at Pathfinder Asset Management, a boutique responsible investment fund manager. This commentary is not personalised investment advice - seek investment advice from an Authorised Financial Adviser before making investment decisions.

Tags: Pathfinder Asset Management

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Comments from our readers

On 14 August 2018 at 9:31 am Brent Sheather said:
The first rule of responsible investing is "keep your fees as low as possible" ie as per NZ Super Fund, ACC etc etc. Therefore "the best negative exclusion" is to exclude high cost, active fund managers who talk up responsible investing to deflect attention from their high fee structures. It is better to invest widely and donate what you save on fees to charities. The US Department of Labour and AQR have a lot to say on this topic and none of it supports ESG.
On 14 August 2018 at 1:30 pm Graeme33 said:
I couldnt agree with Brent any more strongly.regardless of Facebook being considered a good or bad company..I am sure most Kiwi investors would be far better off to have had money in Facebook from the early days than many of the poorer performing Kiwi funds that tout this Ordinary discussion and seem incapable of delivering even above average returns and charge so much for their efforts.Graeme Adams
On 14 August 2018 at 4:45 pm Graeme33 said:
To add to this,what I dont like about this ESG conversation, I believe its gives people some Illusion that their returns will be better...as Brent mentions the data may suggest the results are more the opposite...maybe funds that support this augument so strongly should have to issue some sort of Health alert that their returns are likely to be inferior to many benchmarks...I think this goes against a bit of thought out their ,but I think it is correct still.Graeme
On 15 August 2018 at 8:29 am John Berry said:
Hi Brent and Graeme

There's a wealth of international studies showing responsible investing does not come at a cost. An example - the Responsible Investment Association of Australasia just released their annual benchmark report for Australian funds. Compared to conventional Australian equity funds and index, responsible funds outperformed over 3, 5 and 10 years (underperformed over 1 year). Compared to conventional multi-sector funds, responsible outperformed over 3,5 and 10 years (identical return for 1 year). Compared to international funds the results were mixed. Graeme - be interested to see your research showing a "health warning" is needed for responsible funds...
If returns are the same, focusing on environmental and social impacts of investing, and engaging with companies, certainly beats investing regardless of how harmful the activities are.

Regards
John
On 15 August 2018 at 10:14 am Michael Gray said:
There is also a growing body of evidence supporting the incorporation of ESG considerations into the investment process leads to better-informed investment decisions.
Also, as you know, “Responsible Investing” is a broad church with varying degrees of implementation, for example it is possible to incorporate ESG into the investment process yet not have a specific policy of negative screening and exclusions. A RI approach doesn’t necessarily lead to wide ranging stock and sector exclusions.
Therefore, the criticism or fear of missing out due to a RI needs to be taken with a level of perspective.

The NZ Super Fund is an interesting example, they do have an appropriate fee budget to manage the Fund, which does not exclude them investing into higher fee investment strategies, e.g. hedge Fund strategies and Private Equity, yet they run a global best practice Responsible Investing approach. It would appear you can have both, appropriate fee level and an industry best practice RI approach. They certainly believe this will result in better investment outcomes over the longer term and will result in more assets to pay out to the Government from the Fund in the future.
On 15 August 2018 at 1:23 pm Brent Sheather said:
Hi John

Have to disagree on that. Even if returns are the same, and the theory suggests that they will be lower in the long term, the fee differential i.e. maybe 150 – 200 basis points on your fund for example inclusive of trading costs including market impact versus 10-15 basis points for a Vanguard ETF means that returns after fees will be lower. Interestingly the DOL in the US has warned fund managers not to concentrate too much on ESG factors. Furthermore Cliff Asness at AQR also argues that, due to cost of capital issues, the returns of SIN stocks will be higher, all other things being equal.

What really upsets me about ESG is that its promoters talk about doing the right thing then inflict egregious levels of fees on their victims without fully disclosing that investment theory says that returns from ESG stocks will be lower in the long run. By the way I don’t manage an ESG fund or a SIN stock fund so consider myself a neutral commentator on this issue. I could also argue that not investing in weapons raises the cost of capital for the weapons industry making it more expensive for the western world to defend itself which might turn out to be a particularly dumb move in 20 years or so. You might remember that Britain neglected its armaments industry just ahead of World War II and had to be bailed out by the US.

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