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Posted inESG

Beyond the greenwash – ESG’s identity crisis

Debt and equity assets under management by socially-conscious Europe-domiciled funds stood at €294bn at the end February this year. More than double the €140bn held by ethical debt and equity funds at end-May 2013, according to Morningstar.

On the surface, the jump suggests environmental, social and governance (ESG) has become an increasing priority for the industry.

There have been numerous fund launches over the last year hailing ethical and sustainable credentials – shunning pollutants, tobacco and guns.

But ethical funds still command less than 5% of assets under management (AUM) in Europe. Five years ago, it was 4%. The uptake has been modest compared to growth of the European asset management industry as a whole over the past five years. Non-ESG funds AUM stood at a whopping €7.8trn at the start of the year.

Is the industry really changing in a substantive way? How much of the rhetoric is greenwash? Are people talking the talk but not walking the walk?

Slow traffic

Recent research from Morningstar reveals active funds with a sustainable tilt have bucked the wider industry trend that has seen outflows from conventional active funds. It also showed passive sustainable strategies have seen a “high and stable growth” over the past five years.

The firm’s analysis found the market share of actively managed funds classified as ‘sustainable’ in its database increased from 11.4% in 2015 to 12.4% in 2016 and 12.7% in July 2017. Meanwhile, the market share for passive sustainable funds marginally increased from 1.5% to 2.4% and 2.4%, respectively.

The largest institutional investors tend to lead the way on sustainability, but interest from retail investors is growing. According to Global Sustainable Investment Alliance figures, quoted by Morningstar, retail investors accounted for 25.7% of global assets in sustainable funds in 2016, compared with 13.1% in 2014 and 10.7% in 2012 (see chart 1).

Hortense Bioy, director of passive funds research, Europe, and sustainable investing research specialist at Morningstar, concedes the speed of traffic towards ESG is slow, but says “we have seen inflows into those funds”.

Net flows into socially-conscious European-domiciled debt and equity funds was €30bn in the 12 months to end May this year, according to Morningstar.

“You have more products, but those products have been launched to meet demand,” she adds. “We see consumers changing their behaviour and more investors want to make an impact.”

Slow on the uptake

If there is such a demand and everyone’s talking about ESG, why are the flow percentages still very small?

It is clear, for a start, that ESG has an image problem.

Simply labelling something ‘ethical’ or ‘sustainable’ is not clear to investors, as Matt Christensen, global head of responsible investment at Axa Investment Managers, says.

“There is a lot of talk on the topic but the money flows into this are not clear,” he says.

Christensen says investors are “suspicious, confused or curious at best” by the various terms associated with ESG that get bandied about.

“It has been a hard area to create a simple story of what it means to do these different types of techniques. People don’t always know the difference between an ESG integrated approach versus an impact investment approach,” he says. “It makes it challenging for the punter who just wants a good sustainable investment product.”

An image problem

Jason Hollands, managing director at Tilney Group, agrees that ESG suffers an image problem because people wrongly assume such funds will result in reduced returns.

This misconception is often exacerbated by the marketing behind funds which tends to be daubed with images of wind turbines and trees, he adds.

“Most ESG funds are invested in very recognisable companies, not niche green energy companies or social impact projects,” says Hollands. “The pigeonholing of ESG as a niche interest can sometimes mean investors are only offered such funds on request, rather than proactively presented with them as an option – as a result interest is not being fully realised.”

Hollands says ultimately awareness of ESG factors should be part of good risk management and not just something of special interest to investors with strong principles.

“After all, companies that are transparent, have good governance and are aware of their operational reputational risks are more attractive stewards of capital than businesses that are opaque or cavalier,” he adds.

A growing body of research backs up the case for incorporating ESG into the investment process.

According to Hermes Investment Managers’ quantitative scoring methodology, companies with poor corporate governance tend to underperform well governed companies by an average of 30 basis points a month.

However, the asset manager said that it is still too early to conclude authoritatively that companies with attractive environmental and social characteristics outperform.

Andrew Parry, head of sustainable investing at Hermes, says: “One person’s morals is another’s idea of a good night out, but we have to be good investors no matter what we do.”

But he says just looking at it and paying lip service to ESG will not make you good at it; it must be ingrained in the investment process.

And it is not just equities where this is the case. Hermes also found companies with the weakest ESG credentials, tend to have the widest credit default swap spreads which essentially means riskier companies from a credit perspective tend to have worse ESG credentials.

Similarly, MSCI research found a significant difference in performance between government bonds with similar CDS spreads but different ESG ratings, concluding the higher a country’s ESG rating, the better its government bonds perform.

Acting responsibly

Wealth managers are embracing the trend.

Amanda Tovey, investment manager and head of direct equity at Whitechurch Securities, says there is increasing evidence to suggest ESG analysis can identify the bestrun companies.

Whitechurch runs a range of ethical portfolios using both positive and negative screening on funds and direct equities.

Tovey says: “The funds we include within these portfolios use ESG analysis as part of their process when it comes to stock research to ensure that companies are acting in a responsible way in these areas.

“We are seeing an increasing interest in this area for clients with the AUM of our ethical portfolios doubling in the last year.”

Walker Crips also believes in the power of ethical investing and its Alpha: r2 range of managed portfolios uses ethical data provider Ideal Ratings to screen its UK equities in what the managers term a “light green” approach, but also offers clients a “dark green” fully-screened option.

Gary Waite, a manager of the Alpha: r2 range, says: “ESG screens add another risk lens. We see this as a genuine addition to the standard investment process.”

However, he notes it is often the case that as soon as the term ‘ethical’ comes up, most advisers default to the standard models, suggesting there remains an aversion to the process.

Another obstacle the Alpha: r2 manager faces comes from running the portfolios against standard benchmarks such as the FTSE 100. This is because such indices are dominated by finance and natural resource companies which ethical funds are typically light on and, of course, these indices have done well during the bull run.

“So there is a variation on relative performance if you invest ethically because you invest in a subset of different stocks,” adds Waite, “but over the longer term we expect good ethical companies to structurally outperform, so it makes sense to invest in companies that have better ESG scores.”

Impact generation

It seems the demand for sustainability is going to increase as wealth is passed down generations because younger people tend to be more in tune with “doing the right thing” with their money.

According to Morningstar, alluding to the Morgan Stanley Sustainable, Responsible and Impact Investing Trends report, high net-worth millennials express a greater interest in sustainable and impact investing.

The report found the level of ‘overall interest’ in the area was 82% among HNW millennials versus 45% for HNW individuals generally. Meanwhile, for sustainable investing this was 80% and 55% respectively, and for impact investing, 78% and 45% (see chart 2).

Bioy says: “For some it is investing in something in line with their values, especially the younger generation and women – they think more about the impact they make in the world.”

As Walker Crips’ Waite says, there is “a wall of money” entering the retail sector over the next decade or two that will demand a higher level of engagement from companies on issues that affect everything from climate change to working practices.

“For us, it makes sense to tailor our portfolios to those individuals who look for those characteristics,” he adds.

Sebastian Cheek

Sebastian joined Last Word Media in 2017 as editor of Portfolio Adviser. He previously spent 10 years as a journalist and editor in the UK institutional investment sector, most recently as editor...

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