Financial advisers opt for ESG overlay to manage investment risk
30 October 2018: In the wake of recent governance scandals in both developed and emerging markets, incorporating non-financial indicators such as environmental, social and governance (ESG) factors into investment decisions should play an increasingly important role in a financial adviser's fiduciary duty to mitigate risks, while maximising investment performance on behalf of their clients.
This is according to Roland Gräbe, Head of Tailored Fund Portfolios at Old Mutual, who says that growing pressures around compliance from regulators and concerns from clients about management, performance, unsustainable corporate practices, and costs, has created a need for investment products that incorporate ESG into the investment criteria to protect client against value destruction.
Gräbe refers to a recent report looking at US equities by Merrill Lynch that demonstrates how incorporating ESG factors into an investment strategy can aid in mitigating price-earnings volatility associated with poor governance. "The report found that companies in the top-fifth in terms of ESG ratings from 2005-2010 experienced the lowest (32%) volatility in earnings per share in the subsequent five-year period, while companies with the worst ESG ratings averaged 92% volatility."
He adds that MSCI's decision to remove international car manufacturer Volkswagen (VW) from the MSCI ESG index - prior to the company admitting to using defective software to cheat strict carbon emission tests - presents another strong argument in favor of integrating ESG factors into the investment decision-making process to mitigate the risk of poor governance.
"While traditional indicators such as elevated warranty expenses were raising questions, MSCI noted a general deterioration of VW's corporate governance practices. They took action by removing the company from the All Country World (ACWI) ESG index in May 2015 - four months prior to the scandal that destroyed millions of dollars in share price value for VW investors," says Gräbe.
He says that investors are also increasingly concerned about the impact of the long-term risk associated with climate change and social inequality on the performance of their investments. "Many investors, in particular millennials - the generation currently aged 18 to 34 years - and high-net-worth individuals, have shown increased awareness of the negative impact of carbon emissions on the environment, as seen with VW scandal. These investors are increasingly allocating capital towards initiatives that address both global warming, as well as the rising rates of social degradation, such as a rising incidence of child labour, experienced in poorer developing nations."
Jon Duncan, Head of Responsible Investment at Old Mutual, says that the global trend towards passive ESG investments driven by a consumer demand for sustainable returns has resulted in a wider availability of ESG index tracker funds, thanks to improved ESG data on companies allowing for new approaches to sustainable investing.
"Some may think investors sacrifice returns when taking ESG matters into consideration, but research confirms otherwise. According to a meta-study of 190 different sources, 80% of the reviewed studies demonstrate that prudent sustainability practices have a positive influence on investment performance."
Sustainability is a macro-thematic trend adds Duncan, who believes that the South African market is ripe for ESG investment strategies. "After having experienced steady progression in the institutional investment space, we are seeing that the general perception of sustainable investing is shifting in the retail market, with people becoming increasingly mindful of ESG factors and the role they should play in an investment mandate."
Gräbe says that indexation with an ESG over lay offers investors a competitive strategy that can compete on price of traditional market cap passive strategies. "ESG index tracker funds essentially offer a viable, cost-effective solution for passive investors who, while mandatory holders of the index, are looking for a practical alternative to avoid the unsustainable practices of many listed companies," says Gräbe.
He says that the range of global discretionary model portfolios were launched in response to requests from financial advisers. "The offshore low cost solution with an ESG overlay - the first in South Africa - is exclusively available to independent financial advisers and targets real returns by incorporating mandates that track ESG equity indices in both emerging and developed markets.
"Incorporating ESG factors into investment decisions not only drives performance over the long term, but also ensures that an adviser is acting in the best fiduciary duty of the client by reducing investment risk with a cost-effective approach," he concludes.