The rise of responsible investing

South Africa has joined the ranks of the global investment community in incorporating environmental, social and governance (ESG) factors into its mainstream investment processes. This practice is steadily gaining momentum as part of the range of investment opportunities and strategies for retirement funds to consider. Andrew Rumbelow, Segment Head for the institutional business at Sanlam Investments, unpacks the strong business case behind it.

What is responsible investing?
Responsible investing is a wide-ranging subject which encompasses the environmental, social and governance (ESG) aspects of investing. Responsible investing, which has attracted increased awareness globally, particularly for retirement funds, is an investment discipline that considers specific ESG criteria to generate long-term competitive financial returns along with measurable social and environmental impact.

Responsible investing, as a recent investment practice, is set to become a major game-changer for retirement funds in the medium term (Towers Watson Global Pension Asset Study, 2016). We’re seeing an increasing demand by fiduciaries for their asset managers to more explicitly bring ESG practices into the way they are managing retirement fund assets on behalf of their clients. We have seen this demand reflected in 2 ways:

1. direct, explicit investing into ESG-heavy portfolios (eg: alternative energy portfolios) with a direct, measurable impact;
2. incorporation of broad ESG factors into the way asset managers evaluate the range of investment opportunities available.  In particular, fiduciaries are demanding better stewardship (the careful and responsible management) of the measurement, disclosure and analysis of these factors.

Regulatory context
The United Nations Principles for Responsible Investment (UN PRI) first set the scene for sustainability investing in 2006. This was supported locally both by the introduction  of the Code for Responsible Investing in South Africa in 2011, and subsequent changes to the regulation governing pension funds in SA (Regulation 28) in 2012. These set out prudential guidelines for retirement fund investments to incorporate ESG into their overall risk mitigation and investment decision-making processes.  As a result, the fiduciary duties of retirement fund trustees have expanded significantly and ESG factors are now seen as part of the normal delivery of superior risk-adjusted returns for the ultimate benefit of fund members.

However, regulatory impetus and global awareness aside, there is a very strong case to be made for the superior, risk-adjusted returns responsible investing can reward you with, explains Rumbelow. There is a growing body of evidence that suggests that ESG factors, when integrated into investment analysis and decision making, may offer investors potential long-term performance advantages.

A strong business case for responsible investing
Numerous studies have been conducted the world over to support the case for responsible investing as a driver of financial outperformance.  The benefits associated with responsible investing include an improved risk/return profile, diversification, and support of long-term economic growth (source: Investment Solutions, BATSETA Conference, 2015).

According to a study by Morgan Stanley (2015), investing in sustainability has often exceeded the performance of comparable traditional investments. This is on both an absolute and a risk-adjusted basis, across asset classes and over time.  Sustainable equity mutual funds have also been shown to generate equal or higher average returns, and equal or lower volatility than traditional funds.   There is also a strong positive correlation between corporate investment in sustainability and operational and stock price performance, based on a review of existing studies done by the Morgan Stanley Institute for Sustainable Investing, 2015.

In a study by Oxford University in 2014, several key conclusions were drawn (Clark, Gordon, Andreas Feiner, and Michael Viehs, 2014):

• sound sustainability standards can lower the cost of capital;
• there is a positive relationship between stock performance and good sustainability practices;
• robust ESG practices tend to improve operational performance;
• pursuing sustainability strategies generally results in improved corporate governance;
• firms that are focused on sustainability are also more likely to better manage environmental, financial and reputational risks, which is more likely to lead to lower volatility of cash flows.

Separate case studies in Australia, specifically on its sustainable superannuation funds, and the US, are persuasive.  Both studies revealed increased competitive performance by responsible investment funds compared with their mainstream investment counterparts (SuperRatings, 2015; Harvard Business School, 2011).

The case is compelling: responsible investing is a self-fulfilling virtuous cycle. In a simple example, firms that reduce waste and utilize natural resources more efficiently could see increased profitability through reduced costs and increased efficiency, which makes them more attractive investments and drives their share prices up, which in turn creates profitability and healthy balance sheets, increased dividend payouts, etc. To add to the impetus, within the last month two influential investment ratings agencies have come out with sustainability ratings for funds, which will allow investors to see which funds hold more sustainable companies than others.   Morningstar now rates over 20 000 funds, and MSCI, which launched a similar product only a few days later, tracks 21000 funds globally (Lise Pretorius, 2016).

A new era of millennial investors
According to research done in the 2015 Sanlam Benchmark Survey, a growing number of millennial investors are expressing a desire to “do good while doing well.”  Advice from today’s pensioners is informing their thinking and these younger generations are becoming increasingly more critical of unethical investment behaviour. These young millennials are looking for opportunities for financial investments that have both environmental/social impact as well as a profit motive, and more retirement funds are being set up explicitly to pursue a “double bottom line”. Millennials experienced the financial crisis and all the market volatility that went with it early on in their careers, which has had a significant impact on their mindsets. As a result, there is a growing acceptance among fiduciaries and asset managers about the importance of environment, social and governance (“ESG”) factors in investment returns.

How millennials think:

Source: UBS Investor Watch, 2014

What is the relevance for retirement fund trustees?
In South Africa, the retirement fund industry is significant in terms of its scale as well as the impact it has on the livelihoods of working South Africans and the broader economy. The objective of any retirement fund is to provide members with a retirement benefit when they retire. But retirement funds don’t exist in a vacuum; they operate within our economy and a fund’s ability to meet its objectives is therefore inextricably linked to the growth and success of our (and other) economies.  It can be argued that well-designed solutions which support the long-term viability of the environment will result in positive investment outcomes.  Responsible investing should therefore not be seen as an act of benevolence or charity; there is a viable investment rationale behind it as we have already outlined.

Trustees are thinking beyond traditional approaches to asset class returns, and considering new approaches.

Importantly, trustees have a fiduciary duty to act in the best interests of those whose assets they are responsible for. This means anticipating and forecasting the impact of future trends such as alternative energy and climate change, which materially affect investment performance as well as the quality of life of retirees.

“Sustainability issues should feature on the agendas of every retirement fund’s investment committee”.

How to implement responsible investing                                                                                                                      
Ideally, retirement funds should be incorporating responsible investing into their investment objectives and mandates to ensure their asset managers explicitly consider ESG factors. Asset managers should therefore be poised to integrate environmental (and other) risk factors into their everyday risk assessment processes and investment decisions, as core to prudent long-term investing.

As part of incorporating environmental risk into long-term investment decision-making, trustees may choose to invest directly in opportunities that offer both financial reward and environmental or social value.  This could involve financing projects or firms that aim to preserve, uplift or rehabilitate the environment. Or they could outsource this process to their asset managers and asset consultants, who would then incorporate ESG factors into their overall investment analysis and portfolio construction processes, as trustees may find it difficult to predict impact on portfolios.

Source: Kudos Africa, Bowman: 2016

How asset managers can help
Asset managers and asset owners can incorporate ESG issues into the investment process in a variety of ways. Some may actively seek to include companies that have stronger ESG policies and practices in their portfolios, or to exclude or avoid companies with poor ESG track records. Others may incorporate ESG factors to benchmark corporations to peers or to identify “best-in-class” investment opportunities based on ESG issues. Still other investment managers systematically integrate ESG factors into traditional financial analysis and investment processes as part of a wider evaluation of risk and return. Impact investing is where asset managers select specific investments, typically made in private markets, aimed at solving social or environmental problems.

At Sanlam Investments, our partners in this field, Cambridge Associates, have identified four approaches for institutional  investors to better understand and manage ESG risks: (1) incorporating environmental risks into investment processes; (2) providing greater transparency, disclosure and reporting on environmental risk metrics by asset managers, while introducing an environmental risk lens to the due diligence and monitoring process; (3) proactive hedging via low-carbon index products, derivatives, or use of active managers who specifically employ environmental metrics; and (4) policy-level exclusion of fossil fuel and other sectors (source: Cambridge Associates in association with Sanlam Investments, 2015).

Measuring the effectiveness of responsible investing
The big questions focus around how to accurately assess and measure impact, and the viability of simultaneously achieving environmental impact and market-related returns. Here measurement is critical. When looking at direct ESG investments, it is easier to measure the extent to which ESG has been incorporated as the outcomes are clear. But for bigger portfolios which do not have pure ESG strategies, but rather have ESG factors incorporated into their overall assessment processes, it becomes a little more challenging.

Asset consultants could assist by assessing managers’ capabilities in this specialist area and offering guidance to asset owners. Additionally, investment managers should be able to provide effective processes to their clients and advise fiduciaries on how to implement an effective sustainable investment strategy.

The good news is that responsible investing need not generate additional costs for portfolio performance compared with conventional investments. Therefore, institutional investors should perceive this as a better way to invest, as they can achieve high performance while still addressing environmental, social and ethical concerns.

SIM’s approach to responsible investing
As part of Sanlam Investment Management (SIM)’s pragmatic value investment philosophy, sustainability is embedded as a core process that can result in more insightful research and a better understanding of the potential for companies to deliver sustainable cash flows into the future. By taking the long-term view, non-financial (eg: environmental) data that affects overall valuations is analysed. These issues are typically related to the quality of companies’ relationships with their broader stakeholders and their responsible stewardship of natural resources, as well as their own governance. Acting in client’s interests, an environmental attribution analysis can be performed to analyse the overall impact of investment decisions, in terms of potential environmental damage costs. SIM are also able to conduct an analysis of the carbon footprint of clients’ portfolios, should they desire. Typically this would form part of annual feedback sessions.

Conclusion
It is clear that industry needs to move towards providing a more complete view on financial as well as non-financial performance (corporate as well as societal/environmental value). Increasing disclosure by asset managers could help fiduciaries manage ESG-related risk exposure more effectively, optimise their longer-term investment performance, and effectively meet their fiduciary duties. Investors could consider direct, solution-oriented strategies to capitalize on investment opportunities linked to alternative energy, for example. This could include renewable infrastructure, smart energy, and energy efficiency in buildings.

Dislaimer

At Sanlam Investments, we are trying to raise clients’ awareness around the longer-term opportunities associated with responsible investing, and to help shift perceptions in the industry. This is supported by increasing evidence of the link between good sustainability performance and enhanced investment returns. We believe that in the context of increasing social and environmental challenges (such as climate change) and growing uncertainty, the business case for responsible investing will become more visible. For truly long-term investors, integrating a more comprehensive set of risk factors and opportunity sets into investment decision-making is a sensible and necessary approach. There are sound reasons for sustainable investing and we encourage trustees to consult with us to think beyond traditional investment returns.

Sanlam Investments subscribes to both the Code for Responsible Investing in South Africa (CRISA) and its forerunner, the United Nations Principles for Responsible Investment (UNPRI). In doing so, we aim to comply with international best governance practice, in particular to promote a relationship of trust between all relevant stakeholders and to contribute to the ongoing and long-term sustainability of listed companies.