Towers Watson Asset Manager Review
INVESTORS typically focus on the possible financial rewards of an asset before investing. But are there benefits from thinking more broadly about the social impact of these investments? Does it pay to be good, or green?
Logically, one might think that well-governed companies that operate in an ethical, sustainable and environmentally friendly manner should deliver better returns for their shareholders over the long term.
This is backed up by a study from the Harvard and London Business Schools, showing that such companies significantly outperform their counterparts over the long term.
On the other hand, the JSE’s Socially Responsible Investment Index has underperformed the All Share Index over most measurement periods up to March 2015.
And a study by London Business School academics Dimson, March and Staunton concludes that tobacco stocks have significantly outperformed the overall equity markets in the US and the UK over a very long time period. Other studies also show that “sin” stocks like alcohol, tobacco and gambling have delivered superior financial returns.
Trustees and investors need to think carefully about their own definition of responsible investing. Does this mean investing only in companies that rank highly on published Environmental, Social and Governance (ESG) criteria and operate on a sustainable basis for the long term?
This approach does not automatically preclude investment in fossilfuel producers that contribute to climate change, or tobacco stocks that promote a product that causes longterm health problems for their customers. So should a responsible investor directly avoid investing in companies that contribute to climate change or those that may cause other kinds of “social harm”, on ethical and moral grounds? Or can responsible investment decisions be based on both moral and financial grounds?
Fossil-fuel producers are currently under the spotlight, with a global disinvestment campaign largely driven by students and the academic community. Various institutions, including high profile foundations like that of Stanford University, are disinvesting from coal miners or fossil-fuel companies in general.
We believe this campaign is largely driven on moral grounds, but it may also make sense to avoid fossilfuel companies from a financial perspective.
The argument is that these companies may be prevented by climatechange legislation from economically exploiting all their reserves, so that some fossil-fuel reserves may become “stranded assets”. If this risk is not reflected in the current share prices of these companies, future returns may be disappointing.
There is also the risk that companies will be held liable for the effects of their actions on climate change under the “polluter pays” principle. It is therefore clear that ESG factors can have a material effect on the risk-return profile of investments.
A common response to the disinvestment campaign is that remaining invested allows shareholders to engage with company boards and management, to put pressure on them to change their business practices. Engagement is seen as a more effective way of communicating concerns to company management. Walking away by simply selling shares in a large sector like oil production, for example, would just mean that the shares are bought by less active and less socially conscious investors.
The supporters of engagement also argue that disinvestment from fossil-fuel producers makes little sense, because this targets the producers of energy raw materials, rather than the consumers of the energy and energy products. Why should Sasol be a divestment target while Apple, which produces millions of energy-consuming electronic devices, escapes?
The disinvestment campaigners counter that progress made through engagement has been slow and generally ineffective, while disinvesting sends a stronger and more public signal to management. Some supporters of the disinvestment campaign believe that the most effective way to engage is to sell the bulk of one’s holdings in targeted companies while retaining a small number of shares to maintain a communication channel with company management. Disinvestment, they believe, gives them teeth.
Recent trends suggest that globally, institutional investors are increasingly behaving in a “responsible” manner. Over 1 300 fund managers worldwide had signed up for the United Nations-supported Principles for Responsible Investment by December 2014, committing to incorporate ESG issues into their investment analysis and decisionmaking processes. In South Africa, the majority of large fund managers have endorsed the Code for Responsible Investing in SA (CRISA).
As required by Regulation 28 to the Pension Funds Act, retirement fund trustees should consider these issues and incorporate their beliefs on the place of ESG considerations in investing into their funds’ investment policy statements.
Pressure to do so may start to come from fund members as well as media and campaign groups, as social interest in issues such as climate change, energy policy, and water and land use increases. Regulatory pressure and the threat of “prescribed assets” should not be discounted either.
Recently, the ANC’s Enoch Godongwana, who heads the party’s economic transformation committee, was quoted as saying that the party is under constant pressure from its constituency to endorse regulations requiring targeted investments aimed at generating growth and development. Of course, there is a risk that pressure to promote (shorter-term) economic growth could conflict with longer-term concerns for environmental sustainability – one person’s meat could be another’s poison!
Importantly, the reputational risks from failing to apply and stick to one’s own policy should not be underestimated. Trustees should take care to adopt policies that are practical and will actually be implemented.
There are various approaches that trustees could take to incorporate ESG beliefs into their funds’ investment strategies.
The favoured approach will partly depend upon the trustees’ “governance budget” (how much time and capacity does the board have to spend on investment related matters?), the investment expertise available to the board (e.g. through its investment advisors as well as the trustees themselves), and the size of the fund and the overall nature of its investments. ESG factors are likely to have most relevance for asset classes like listed and private equity, corporate bonds, property, agriculture and infrastructure development.
Trustees should consider how far their responsibilities to stakeholders, especially members, extend. On a narrow interpretation, their main responsibility is to earn good investment returns taking due account of risk. If tobacco companies (for example) offer the prospect of above-average returns and they operate in a legal and regulated industry, why should funds not invest in them?
A broader interpretation of trustees’ responsibilities could be that, notwithstanding the investment arguments, it is not appropriate to give financial support to a business selling products that damage the health of fund members and the wider society. This argument could obviously be extended to the climatechange arena. But these are complex issues requiring clear and careful thought and debate.
Probably the easiest approach from a governance perspective is simply to require the fund’s investment managers to explain how they incorporate ESG factors into their decisionprocesses. This generally includes an account of how they exercise voting rights and how they engage with company management on specific issues, on behalf of their investors, but should extend to the quality of their thinking on longerterm ESG considerations and how these impact on the fair value of the shares they consider buying.
As investment consultants, our overall rating of a manager will reflect our view of how well they integrate ESG considerations into their investment process.
Where retirement funds are direct owners of share portfolios held in socalled segregated mandates, trustees can develop their own policies on how their investment managers should vote the shares that they manage on behalf of the fund.
A further step would be for trustees to analyse their investment portfolios and (for example) measure their overall “carbon exposure”, or their exposure to companies with a poor ESG rating.
There are various methods to determine carbon exposure, such as an assessment of carbon emissions of listed companies, with the Greenhouse Gas Protocol (GHGP) as the most widely used framework internationally. In terms of ESG ratings, there are specialised service providers offering tools to asset owners and investment managers to measure and manage ESG risk. The aim here is for trustees to understand the areas of vulnerability of their portfolio, which provides a further tool to interrogate their fund managers and assess the quality of their thinking and decision-making.
Trustees could then consider taking steps to reduce the exposure of the portfolio to carbon-related risks or other ESG risks they have identified. This could be done on either an “active” or a “passive” (green indextracking) basis.
Another approach is so-called “negative screening”, where certain kinds of investments are avoided altogether based on ESG concerns, for example fossil-fuel producers or “sin stocks”. Should the portfolio currently have exposure to these stocks, trustees may decide to disinvest from them. Internationally, numerous educational and public-sector funds have chosen this route.
This can be achieved either through an actively managed strategy or using a passive, index-tracking approach – in this regard there are several “fossil-fuel-free” indexes available for investment. Related are the so-called “faith based” investment funds, such as Shari’ah-compliant funds, which exclude investment in “sin” stocks (such as tobacco, alcohol, the adult entertainment industry, gambling and weapons). These may be available in both active and passive variants.
In choosing a “good” index to track or framing an investment mandate for an active manager with suitable ethically-based exclusions or restrictions, trustees will have to consider which of the various (possibly competing) ESG factors and risks they want to give priority to.
This points to one of the difficulties with this approach – there is a risk that being too purist will mean eliminating a large part of the investment universe from consideration, and thereby drastically restricting the “opportunity set”.
Trustees can also choose a proactive approach, by specifically seeking investments that generate social and environmental benefits in addition to financial returns. This approach is also called “impact investing”. An example would be an investment in renewable energy projects.
Another proactive approach is to position portfolios to capture the upside potential of climate change. Hence trustees could consider making investments in companies that will perform well in a low carbon economy such as those involved in energy efficiency, renewable energy or clean technology.
Internationally, there is an array of indexes available that provide exposure to these market segments, but there are also specialist investment managers and investment funds which manage targeted-investment portfolios on a traditional active basis.
Responsible investing is a relatively new concept, but it has gained momentum in recent times, encouraged locally to some extent by the provisions of Regulation 28.
It can provide a framework for trustees and investors to recognise what is socially beneficial as well as what is profitable. It is certain to place some extra demands on trustees and fund managers, but we believe the tide is running in this direction, and more importantly, longterm thinking that incorporates environmental, social and sustainability considerations should be rewarded by better long-term returns. Frederick Muller and Erich Potgieter, Towers Watson
May 2015