Environmental, Social and Governance investing: one of the biggest hot topics in pensions for 2020, if somewhat overshadowed by COVID-19.
However, much as COVID-19 is seen differently around the world , there can be very polarised views on ESG too.
What is ESG?
ESG investing is not necessarily about investing in “good” companies but is about ensuring that the huge power pension scheme investors have in influencing the world’s economy is, at the very least, being considered fully.
With regulators, industry bodies and (importantly) pension scheme investors being increasingly focused on this, we thought it might be helpful to try and clear some of the fog.
The basic factors to consider
Before we share a few thoughts on ESG investing itself, here’s a quick reminder of the two main groupings of factors to consider around investments:
Financial factors – these are factors which are believed to have an impact on investment return and risk. They aren’t restricted solely to the short-term impact they may have on performance, but should also consider the longer-term impact on investments and sustainability. As an example, a pension fund may invest in a company whose long-term performance and continued ability to provide returns to investors would be negatively impacted by the reputational damage that would follow an action that could be seen as harmful to the environment. Therefore the investor may be minded to use their voting powers to influence the organisation to take the short-term cost of improvement in order to reduce the long-term risk.
Non-financial factors – These are factors that do not necessarily have a direct impact on the investment return and risk, but are typically ones that align to investors’ beliefs. In the context of default investment strategies used by pension schemes, it’s difficult to ensure that the fund aligns with all members’ beliefs, however it’s important to consider whether the participating pension members or the sponsoring employer may hold a viewpoint on these factors.
Misconception 1 : Good Stewardship means ethical investing
It’s a common misconception that embedding ESG within your investment strategy requires those running pension schemes (trustees, employers, insurance companies) to adopt an ethical investment structure whereby you may decide to exclude certain investments due to the nature of the organisation (for example tobacco or firearms).
In fact, investing in a way that has ESG principles integral to the investment strategy means ensuring that the investment manager is actively engaging companies it invests in. This isn’t necessarily always about being “ethical” or avoiding investing in certain companies (although it can be if desired), it’s more about influencing the company to do the best it can, whether in long-term returns, by being sustainable or otherwise. Examples include:
- Voting on Board remunerations to ensure they are rewarded commensurately for ensuring long-term success (over short-term profit)
Promoting health and safety standards to reduce the risk of falls in production or financial/reputational detriment from legal claims
Promoting good business ethics to avoid risk from regulatory or public scrutiny
Most pension investors use “pooled investment vehicles” (i.e. invested in a large fund alongside other investors rather than investing directly in assets). Pooled investment vehicles can include these factors in order to positively impact investment return and risk, without skewing the portfolio towards ethical investments.
Misconception 2: You may have to sacrifice returns to “do the right thing”
Analysis into the long-term impact of ESG investing has been relatively scarce due to the speed at which the industry has evolved in this area in recent years. In fact, there has often been a view in the market that you may have to sacrifice investment returns in order to incorporate ESG policies within an investment strategy.
However, financial factors are considered, fundamentally, to improve long-term returns and manage risk.
Our friends at CAMRADATA have been researching the implications of different stewardship models. Recent research noted that from a universe of active Global Equity managers, those defined as Socially Responsible Investors (SRI) funds outperformed those that were not, by an average of 8.19% over the 5-year annualised period at Q2 2020. (Author’s note: that would be a pleasant increase to my pension fund!).
Source: CAMRADATA Responsible investing whitepaper July 2020.
In addition, recent research by Morningstar has compared the performance of ESG with non-ESG funds across a broad spectrum of investments. The research found that broadly 60% of ESG funds outperformed their peers over the longer-term periods of 5 and 10 years. This is the latest research (June 2020) that further supports the view that ESG investing is not detrimental to investment performance, and conversely can have a positive impact.
Fundamentally, the above evidence suggests that building in these factors can be a positive. Of course, past performance is no guarantee of future returns but this certainly shows that investors haven’t sacrificed returns when adopting an ESG focus in recent years.
So, what do we think is important?
At Punter Southall Aspire we believe that when setting a default investment strategy (which the majority of members are likely to be invested in), it’s fundamental to consider all financial factors to ensure that the pension arrangement will deliver appropriate returns and be sustainable over the long-term. Employers, trustees and pension scheme investors should make sure they’re asking the right questions of their pension scheme.
The slightly more controversial part of ESG is the non-financial factors as many individuals, companies and pension providers will have different views on what can be a subjective area. It’s common to cater for pension scheme members who hold strong ethical beliefs through making available appropriate ethically-tilted funds. However, some employers and workforces may also wish to incorporate non-financial factors within their default investment strategy to have a positive impact on the world. If this is an important factor for you, now is the time to take action.
HHave questions about your investment arrangements?