Positioning ESG with your clients
“I can’t go back to yesterday because I am a different person now” (Alice in Wonderland)
"Ultimately investors will need to make a decision on whether they’re investing for ethical and ESG reasons, or for financial returns" so writes lawyer Michael Cotter, in a recent article published in Professional Adviser. I believe this line of thinking exemplifies the level of confusion over ESG which causes so much difficulty in how advisers position Responsible Investment for their clients. So here is some help.
First step: ESG is about reducing risk
At a fundamental level, incorporating ESG represents an additional layer of risk management. This is why so many asset management firms find it easy to say that they are integrating ESG into all their investment processes to a lesser or greater degree (mostly lesser). Analysts are used to looking at companies on the basis of risk derived from the capital structure, operational leverage, competitive environment and legislative threats. They are less used to pricing the risk of environmental disaster, reputational damage or blokeish ‘group think’ in the board room. ESG analysis incorporates or enhances understanding of factors such as company leadership structure, the business’s attitude to environmental risk and the business’s attitude to maintaining its social license to operate. Some asset managers say that these factors have always formed part of the analysis process, but there can be no doubt that the increased emphasis on ESG analysis represents a step up in this form of risk awareness. Logically, any improvement in risk analysis should improve risk adjusted returns. Conversely, it seems inconceivable that ESG analysis would damage returns, unless that analysis is done or used badly – but that caveat applies to all analysis. Therefore, risk adjusted returns from ESG investing should be an improvement over non-ESG investing, and the decision to opt out of ESG would be the one requiring a profit warning.
People don’t invest for ethical reasons alone.
Everyone who invests, invests for financial reasons. Having decided to invest, investors then decide how they want to invest.
Investment and business theory is based on the principle that managers and investors seek to maximise risk adjusted profits. This is true, but the investment industry is still floundering about what risk means, because there is no one-size-fits-all definition of risk. As we saw earlier, if ESG analysis assesses risk then ESG attitudes need to be part of the investment process. If we respect that the owners of assets have the right to determine how their money is spent, and to determine their own definition of risk, then they must be listened to.
Understand too, that constraints are not always a trade-off between opportunity and ethics. For many Responsible Investors, the perceived correlation between responsibility and profit is a positive one. If an adviser has sufficient grounds for believing that the client’s constraints are too narrow then they should say so, but, so long as the constraints are not overwhelming, that would be a difficult call to make. Certainly, I know of no ESG focused fund manager that has ever complained of having too few attractive investment opportunities.
What should you say to clients?
What I find most difficult to reconcile is the assertion that by adding a non-financial element to their investment objectives, clients are de facto damaging their financial prospects. This is based on the wafer-thin logic that by restricting the pool of investments, one is reducing the opportunity for profit. The inevitable riposte to this is that the potential for losses is reduced at the same time. The important point is that the portfolio be sufficiently diversified. Given the inherent difficulties that human beings have in predicting the future, it is potentially misleading for an adviser to say whether the reduced opportunity set of ESG portfolios is going to perform better or worse than the wider pool. Of course, the advisor may have an opinion but the only thing that can be said with certainty is that the two will differ, and that the client should not feel inhibited from exercising their values.
Asset owners have found their voices now.
The manager of a business is the representative of its shareholders who are entitled to take a view and influence management on the way a business conducts itself. When investment managers are taking instruction from their clients, it is entirely appropriate they take instruction on how clients (the asset owners) would like their assets deployed. In the traditional model, clients delegate their moral choices to advisors who delegate to discretionary managers, who in turn delegate to fund managers who will take a varying degree of interest in the ethics of the companies they invest in. That is an exceptionally long chain of command, but it is one that is increasingly opening up. With vast amounts of freely available information on the impact companies have, clients are right to take an interest and assert that their money works for them within their own values-based boundaries. They should not be deterred by the Fear-Of-Missing-Out and advisers should feel able to position investing with ethics as an improvement in investment strategy.
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Or Call Chris Redman at 0203 750 1810
Chris Redman, Chartered FCSI
Investment Director & Head of Responsible Investment Solutions