October 2021
We are heartened at the pace at which the investment industry is now moving to integrate environmental, social and governance (ESG) considerations into portfolios. For too long this area has been a sideshow to the main event of maximising returns in pounds, shillings and pence – with little or no regard to the wider impact of the underlying businesses on the environment, society at large or indeed on how the underlying businesses themselves are run. Driven perhaps by the climate emergency, combined with pressure from an increasingly informed and vocal client base, change is now upon us – and accelerating rapidly. This is indisputably a positive development, but it brings a new set of challenges. Below we briefly outline our views on these, and how we propose to address them.
First among the challenges is that integration of ESG into an investment process brings complexity. Arguably this is a key reason why widespread adoption has until recently been slow. What was a two-dimensional challenge – maximising returns for an agreed level of risk – becomes a three or perhaps multi-dimensional one. Now the return maximisation target is subject to constraints; the underlying businesses must pass muster in being well run and avoid harm to the environment or society. Ideally, they should contribute positively. This means that measurement and judgement on these matters then becomes an issue. For example, oil major, Royal Dutch Shell has committed to investing $5-6bn annually to green energy and has a plan to be a net zero carbon business by 2050. Is this sufficient to make the company’s shares investable? Or should we prefer shares in a business investing far less, but with no legacy oil business? The need to answer such questions leads to our next point.
Our second challenge is that we must be very wary of shortcuts to ESG-compliant portfolios. Demand for investments which tick the ESG criteria boxes has, unsurprisingly, been met by a willing supply as investment banks and fund houses happily launch new products into the space. This development raises concerns about ‘greenwashing’, whereby lip-service is paid to ESG without the underlying approach changing sufficiently and without the underlying goals of the ESG investor really being advanced in the way they hoped or intended. We now have ‘ESG’ funds aplenty, with labels such as ‘sustainable’, ‘responsible’ or ‘stewardship’ – all of which salve investor consciences and save advisers from the work of having to pick through the details of the underlying exposures – or measuring, deciding and explaining. To address the greenwashing risk the EU has introduced a set of rules, the Sustainable Finance Disclosure Regulations, to govern standards of compliance in this area. These should, in due course, serve to create greater transparency around investment managers’ ESG processes and address ‘greenwashing’. At present, however, not all funds are declaring which EU Article they are meeting, and of course, UK funds are not compelled to comply with these regulations anyway.
The third of our challenges, is that we need to consider whether the move to integrate ESG into portfolios brings with it the risk of skewing portfolios and thereby impacting future returns. Stocks and sectors which have strong ESG credentials, such as healthcare, electric cars or renewable energy may be strongly preferred by investors, but if the underlying business economics are not sound or the valuations are too stretched, performance is unlikely to meet expectations. Stock market history is littered with examples of companies and sectors that became investor darlings – only to subsequently disappoint. The move towards ESG compliance will not be exempt from such risks.
Finally, we should note that investing within ESG guidelines or restrictions is itself a moving target. Previously, the exclusion list consisted mainly of armaments manufacturers and ‘sin sectors’ such as alcohol, gambling and tobacco. In recent years climate change has driven fossil fuel-related businesses onto the ‘potential exclusions’ agenda. At the same time corporate governance has increasingly come into focus as an area of scrutiny. The target will continue to move and evolve, both as more issues, such as modern slavery, get greater prominence on the ESG agenda and as the bar is raised in all areas of concern be they negative impacts on environment or society, or weak corporate governance.
The Heronsgate approach to ESG
Our firm view is that, in the not too distant future, portfolios with integrated ESG standards will become the norm, rather than a subset of an unconstrained mainstream. With this, the idea of separate investment lists, developed to meet the desire for ESG integration amongst a subset of investors, will be consigned to history. The drivers for this are two-fold. Firstly, demand for high standards of ESG within investee companies is likely to continue to grow rapidly, raising the size of assets managed on this basis as well as the degree and quantity of engagement between investors and companies. Secondly, many companies are likely to work themselves off exclusions lists through a process of explanation, reorientation or divestment – while others will be subject to new scrutiny and engagement. Evidence of the amount of effort now going into ESG reporting can be found by reading any major company’s annual report while, in parallel, every fund manager we have met in the past two years, without exception, has a formal strategy for how they incorporate ESG into their investment approach. Similarly, while engaging with investee companies to encourage change might be considered insufficiently proactive, the more aggressive approach of disinvestment and exclusion may well result in poor ESG standards being swept under the carpet. Thus, a much more flexible and considered approach is required – a simple tick box exercise of which companies meet ESG criteria and which do not is insufficient.
Within this framework, we’re aiming to minimise the amount of time we spend trying to cater separately for ESG and non-ESG investors. Instead, we propose taking a detailed, active and flexible approach. Specifically, this means analysing the detail and disclosing to clients the extent of exposure to stocks that would ordinarily not be included in an ESG portfolio. By active, we mean undertaking due diligence into the ESG approaches and compliance used by all of our recommended funds and finally, by being flexible, we mean that our stance on ESG will evolve as new issues arise and as the ESG landscape changes. This will extend, in due course, to reporting on the positive ESG attributes of companies, that is, those companies actively contributing to progress towards ESG goals.
For now, however, and by way of a starting point, we have analysed our models from an ESG perspective and can report that, for example, around 50% of the funds included in the Heronsgate Balanced Model are managed to Article 9 or 8 of the EU Sustainable Finance Disclosure Regulation. The former are those funds which actively target sustainable investments while Article 8 is described as those that are ESG ‘promoting’. With regard to the remaining funds these are mostly, as yet, uncategorised within the EU methodology rather than being non-ESG. We are exploring other ESG evaluation systems such as those provided by MSCI and Refinitiv to identify the most useful way of summarising the degree to which portfolios meet ESG criteria.
Considering the same portfolio from the perspective of identifying those companies that don’t meet ESG criteria, our analysis reveals that it has less than 3% exposure to energy, alcohol, tobacco, and gambling combined (with no exposure to armaments). We believe that this exposure is likely to move lower still over time, both through our fund selections and changes in the underlying portfolios.
As part of our move towards ESG integration, we would very much like to hear your views. Please do contact us.
This document does not constitute advice or a personal recommendation or take into account the particular investment objectives, financial situations or needs of individuals. This document is not intended for further distribution. This document has been prepared with all reasonable care and is not knowingly misleading in whole or in part. The information herein is obtained from sources which we consider to be reliable but its accuracy and completeness cannot be guaranteed. No responsibility is taken for any losses, including, without limitation, any consequential loss, which may be incurred by anyone acting on information in this document. The value of investments and the income from them are not guaranteed and can fall as well as rise and clients may not get back their original investment. Where investments have particular tax features, these depend on the individual circumstances of each client and tax rules and are subject to change in the future. The opinions and conclusions given are those of Heronsgate Capital LLP and are subject to change without notice.
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Heronsgate Capital LLP is a limited liability partnership, registered in England & Wales with registration number OC430243. Heronsgate Capital LLP is authorised and regulated by the Financial Conduct Authority. FCA registered number 933757.
