Register For Our Mailing List

Register to receive our free weekly newsletter including editorials.

Home / 187

Looking behind the screens of ESG investing

Interest in environmental, social and governance principles (ESG) has been growing among investors in recent years. However, in pursuing these preferences, they can severely risk compromising their investment goals. As the popularity of investing sustainably gains momentum globally, how do fiduciaries ensure sound investment outcomes are not compromised in pursuing ESG goals?

Naïve and simplistic screening processes, for instance, can leave clients with highly concentrated portfolios that reduce the chances of them reaching their goals.

Client preferences may also differ within the ESG framework. For example, some may care more about reducing the carbon footprint than about land use and bio-diversity. Preferences around social criteria can also vary.

Simple screening processes may not work

A simple, binary screening process may not be able to accommodate the broad range of issues investors really care about. This dilemma was highlighted in the 2016 Investor Report, a landmark survey on ESG investment, published by the independent group Impact Investing Australia in collaboration with the University of Melbourne. The survey of Australian investors, accounting for more than $300 billion of funds under management, found that while more than two thirds expect ESG to grow in significance, many are put off by inadequate investment solutions.

“There appears to be an unmet need from investors for financial services and advice that incorporate social and environmental impact,” the survey found. “[But] lack of reliable research, information and benchmarks and no recognised investment framework are cited as key deterrents to investors entering the market.”

Fortunately, many of those deterrents are gradually being resolved due to greater knowledge of sustainability topics and more availability of data on companies and their sustainability credentials. In terms of benchmarks, some providers have launched ESG indexes over the past year.

More attention is also being paid to clients’ sustainability and social issue considerations, importantly without compromising long-term investment performance.

This means it is now possible to incorporate sustainability preferences in robust, broadly diversified investment solutions. If designed and implemented correctly, investors can simultaneously pursue their sustainability and investment goals.

It also means asset managers can report their portfolios’ sustainability footprint, providing detailed metrics that give investors the transparency they have come to expect from investment performance reporting.

Growth in ESG is undeniable

The amount held in core responsible investment funds rose 62% last year to $51.5 billion, according to the Responsible Investment Association of Australasia’s (RIAA) 2016 benchmark report.

The most popular strategy among the 69 asset managers offering responsible investing products was screening, both positive and negative. To ensure adequate exposure and not compromise on diversification, strategies are now available that shift capital within particular sectors from companies with the lowest sustainability scores to those with the best scores.

Using this scoring framework, issues such as land use and biodiversity, toxic spills, operational waste and waste management can be considered alongside the dominant metric of intensity of greenhouse gas emissions.

A simplistic screening method can also easily overlook potential emissions from fossil fuel reserves. So while companies with large fossil fuel reserves may not have high emissions, those stored reserves are nevertheless a source of future potential emissions and may face risk of devaluation due to governmental action or the increased availability of alternative energy sources.

A final consideration is that sustainability includes more than just emissions. Penalties can also apply to companies linked to intensive factory farming, cluster munitions and mines, child labour practices, and tobacco.

How should ESG work?

The ideal approach should systematically evaluate sustainability metrics among companies across all major industries, excluding or penalising those that rank poorly while emphasising those with higher sustainability scores.

At the same time, the strategy needs to be broadly diversified across countries, industries and companies, while targeting the sources of higher expected returns, minimising turnover and keeping a lid on trading costs.

For fiduciaries, this opens up an avenue of differentiation by allowing them to tailor solutions that satisfy client convictions around ESG issues while delivering on investment outcomes. The client discovery process is important in providing fiduciaries with a sense of each person’s wealth aspirations and requirements, in addition to their non-material goals.

In the meantime, the RIAA has published a framework to help advisers judge best practices in integrating ESG in investment strategies. These include transparency of approach, the use of systematic processes and evidence of active ownership.

Aiding transparency on the company side are regulatory pressures to improve reporting around ESG issues. In November 2016, the Global Reporting Initiative (GRI) released its new sustainability reporting standards. More than 20 stock exchanges, including Australia’s, now reference GRI in their listing requirements.

Sustainable investing has moved from a fringe to a mainstream consideration for many millions of investors worldwide. The challenge is on now for asset managers to deliver solutions that meet those non-material requirements while still meeting clients’ long-term financial goals effectively.

 

Nigel Stewart is Executive Director of the Australian arm of Dimensional, a global funds manager with assets under management of around $600 billion, about 10% of which are in sustainability or ESG strategies.

RELATED ARTICLES

Impact investing – Australian market in 2014

Beyond the acronym, navigating important ESG choices

Through the looking-glass: what counts is not tied to an index

banner

Most viewed in recent weeks

The nuts and bolts of family trusts

There are well over 800,000 family trusts in Australia, controlling more than $3 trillion of assets. Here's a guide on whether a family trust may have a place in your individual investment strategy.

Welcome to Firstlinks Edition 581 with weekend update

A recent industry event made me realise that a 30 year old investing trend could still have serious legs. Could it eventually pose a threat to two of Australia's biggest companies?

  • 10 October 2024

Preserving wealth through generations is hard

How have so many wealthy families through history managed to squander their fortunes? This looks at the lessons from these families and offers several solutions to making and keeping money over the long-term.

Welcome to Firstlinks Edition 583

Investing guru Howard Marks says he had two epiphanies while visiting Australia recently: the two major asset classes aren’t what you think they are, and one key decision matters above all else when building portfolios.

  • 24 October 2024

A big win for bank customers against scammers

A recent ruling from The Australian Financial Complaints Authority may herald a new era for financial scams. For the first time, a bank is being forced to reimburse a customer for the amount they were scammed.

The quirks of retirement planning with an age gap

A big age gap can make it harder to find a solution that works for both partners – financially and otherwise. Having a frank conversation about the future, and having it as early as possible, is essential.

Latest Updates

Planning

What will be your legacy?

As we get older, many of us start to think about how we’ll be remembered by those left behind. This looks at why that may not be the best strategy to ensure that you live life well and leave loved ones in good stead.

Economy

It's the cost of government, stupid

Australia's bloated government sector is every bit as responsible for our economic worries as the cost of living crisis. Grand schemes like the 'Future Made in Australia' only look set to make it worse.

SMSF strategies

A guide to valuing SMSF assets correctly

SMSF trustees are required to value all fund assets, including property, at market value when preparing the fund's financial statements each year. Here are some key tips to ensure that you get it right.

Economics

Australia is lucky the British were the first 'intruders'

British colonisation's Common Law system contributed to economic prosperity, in contrast to Latin America's lower wealth under Civil Law. It influenced capitalism's success in former British colonies, like Australia.

Economics

A significant shift in the jobs market

The expansion of the 'care sector' represents the most profound structural change to Australia's job market since the mining boom. This analyses how it's come about and the impact it will have on the economy.

Shares

Searching for value in tech stocks

Just because a stock is cheap doesn't necessarily make it good value. This uses case studies in the tech sector to help identify when stocks trading on 30x earnings may be inexpensive and when others on 10x may be value traps.

Investing

Are more informed investors prone to making poorer decisions?

Finance Professor Michael Finke recently discussed the double-edged sword of taking an interest in your investments, three predictors of panic selling, and why nurses tend to be better investors than doctors.

Sponsors

Alliances

© 2024 Morningstar, Inc. All rights reserved.

Disclaimer
The data, research and opinions provided here are for information purposes; are not an offer to buy or sell a security; and are not warranted to be correct, complete or accurate. Morningstar, its affiliates, and third-party content providers are not responsible for any investment decisions, damages or losses resulting from, or related to, the data and analyses or their use. To the extent any content is general advice, it has been prepared for clients of Morningstar Australasia Pty Ltd (ABN: 95 090 665 544, AFSL: 240892), without reference to your financial objectives, situation or needs. For more information refer to our Financial Services Guide. You should consider the advice in light of these matters and if applicable, the relevant Product Disclosure Statement before making any decision to invest. Past performance does not necessarily indicate a financial product’s future performance. To obtain advice tailored to your situation, contact a professional financial adviser. Articles are current as at date of publication.
This website contains information and opinions provided by third parties. Inclusion of this information does not necessarily represent Morningstar’s positions, strategies or opinions and should not be considered an endorsement by Morningstar.