A start to sustainable investing

Do you believe in your investments?

It’s not a question we often ask ourselves. And yet conviction is one of the most important pillars of any successful investment strategy because it thwarts the enemy of compounding: panic selling.

Conviction can have a weak or strong character. We derive the former from the behaviour of the crowd while the latter is based on well-thought-out personal beliefs. No prizes for guessing which one is more resilient and leads to better returns over time.

Sustainable investing requires conviction of the strong kind. It’s a relatively new strategy, so doubt is more likely to creep in when it doesn’t perform as expected. If you’re thinking about incorporating sustainable investing practices into your client portfolios, be they of retail or institutional ilk, the starting point should be the beliefs and goals of the end investor.

Let’s be honest

For many people, climate change is still an intangible threat. And because its impact on them is marginal, the responsibility to fix it, in their minds, falls to someone else. We’re all guilty of such short-term thinking in one form or another. In the context of investing, that indifference has consequences for conviction.

Put simply, if an investor doesn’t feel strongly about mitigating climate change, they are unlikely to hold onto an underperforming investment strategy that excludes emission-heavy stocks.

Thankfully, there are many different challenges that sustainable investing aims to address. Its broad scope is best outlined in the UN’s 17 Sustainable Development Goals (SDGs). If the investor doesn’t care for climate change, maybe reducing poverty, improving education, or ensuring access to clean water will resonate.

To successfully incorporate sustainable investing practices into any portfolio, an honest conversation about what matters to the end investor must be had. If they believe in the underlying cause, they are more likely to hold the strategy line through the inevitable periods of underperformance. In fact, aligning investors with a cause they care about should result in deeper conviction than they might have for traditional investments without an altruistic underpin. Most of us want to make a positive difference.

In a similar vein, an investor’s return expectations need to be considered. Someone who relies heavily on their portfolio income to meet their living expenses is unlikely to think much of a strategy that delivers below market returns in lieu of making a measurable societal impact.

Finding a match

You’ve done the work to understand your client’s beliefs around sustainable investing. You understand how they want to make a difference, and their concomitant return expectations. What comes next?
There are three broad approaches to sustainable investing that investors can take, each suited to different beliefs and goals. They are:

1. Exclusion – avoid investing in companies with controversial or unethical practices
2. Integration – use financially material ESG information to elevate risk-adjusted returns
3. Impact – effect positive socio-economic change alongside financial returns

It’s generally accepted that exclusion is the natural starting point for most investors considering sustainable investing practices. That’s because it’s a relatively simple strategy to understand and implement; don’t invest in business who are doing things that run counter to your values and beliefs.

The underlying motivation here is for the investor to avoid allocating their capital to businesses that might suffer reputational damage and/or financial loss by inflicting environmental or social harm, or whose weak governance structures prejudice its stakeholders. The market is increasingly punitive towards businesses who transgress on these fronts.

Integration also looks to mitigate against such outcomes. But instead of taking a predominantly defensive stance, it aims to improve the risk-reward profile of the investments made.

It does this by incorporating environmental, social and governance (ESG) information that is considered ‘financially material’ to the success and sustainability of the business in question. What counts as material varies depending on who you ask, what industry the company operates in, and which country they call home. In other words, it’s nuanced and requires a lot of work to implement.

The final strategy builds on the first two, but has an explicit goal of making a tangible, measurable social and/or environmental impact. Hence, impact.

Investors who use this approach still want to generate a decent return, but they are equally motivated to effect positive change by allocating their capital to businesses that prioritise the betterment of the socioeconomic fabric and the encompassing environment.

Practical implementation

Whether you’re a retail or institutional investor, improving the sustainable investing credentials of your client portfolios is largely dependent on the actions of the fund managers investing their money.

To be sure, we are not advocating that you immediately divest from a manager because they’re not a PRI signatory or don’t have a slick ESG brochure; these signals mean little in isolation. Instead, you can begin assessing the authenticity of a manager’s sustainable investing practises by adopting a simple three-pronged approach:

1. Exclusion consistency: if a manager purports to be a climate change activist, for example, you should question a coal miner in their portfolio.

2. Voting alignment: if a manager purports to be a champion of positive socio-economic change, you should question their voting in favour of excessive executive remuneration packages.

3. Engagement levels: if a manager purports to take governance seriously, you should question the lack of detailed records around their engagements with company management on such issues.

The onus falls on the manager to provide satisfactory answers to your questions. If their responses aren’t forthcoming or articulate, then the risk that your clients will be exposed to companies that suffer reputational damage or financial loss due to ESG transgressions will be heightened.

Good peer pressure

If there’s a trend gaining momentum globally it’s the ability of shareholders to influence the actions of the businesses they invest in. Another is the ability of investors and intermediaries to influence the actions of their chosen fund managers. Both require increased dialogue.

As a retail or institutional investor, engaging with your chosen fund managers around their sustainable investing practices serves a dual purpose. The first is to ensure suitability in the context of your client’s needs. The second is to be a good influence on them.

An excellent way to stimulate debate on this front is to share what other managers are doing well in the space. It can help provide the spark and motivation necessary for them to embrace sustainable investment practices in a meaningful way. Working through these issues with a manager you know and trust is easier than starting a relationship with a new manager from scratch.

Work to understand the beliefs and goals of your clients, match those outcomes with the appropriate sustainable investing approach, and then engage with your managers to ensure alignment between the two. To begin with, those are solid steps to build strong-form conviction around investing sustainably.