COMPELLING RETURNS

There is often a misperception from investors (as well as asset managers and advisers) that responsible investment practices detract from investment performance.

The claim is that the consideration of environmental, social and governance (ESG) factors in the investment process, coupled with active stewardship of assets, is costly, potentially constraining and detracts from performance.

However, the emerging academic and industry evidence, supported by our own analysis, paints a very different picture.

So how can investing responsibly give investment managers and their clients an edge? And what are the keys to getting it right?

WHAT DO WE VALUE?

Responsible investment is often confused with the simple process of excluding stocks based on ethical criteria. The reality is that responsible investment is a far more nuanced approach that is primarily concerned with the long-term impact of ESG-related risks and opportunities on a company’s cash flows and valuations.

Perhaps one of the more striking points to consider is that in the modern era most company values are derived from intangible assets – such as goodwill, intellectual property rights, product safety, reputation, innovation, management quality, staff loyalty, social licence to operate etc – rather than tangible assets such as plant and equipment. Recent estimates indicate that the market value of the S&P 500 arising from intangible assets sits at 84%, up from less than 20% in 1974 (see Figure 1 below). Given that many ESG issues directly influence a company’s intangible value, it makes sense to understand how exposed a company is to ESG issues, and how capable the leadership team is of managing these risks and opportunities.

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In essence, sustainability is a trend shaping the competitiveness of firms across all sectors, and companies that can respond early relative to their peers will show lower cost of capital, better resource efficiency, stronger innovation, better social licence to operate, stronger staff retention and, ultimately, stronger competitive advantage. The most compelling research in this regard is from Harvard Business School over a 20-year period – their findings show that companies with strong sustainability performance showed both market and accounting based outperformance against their peers with weak sustainability performance1.

BUILDING OUT THE EVIDENCE

Over 300 academic and industry studies have now been published analysing the impact of ESG strategies on investment performance. We have assessed many of these studies and the evidence to date suggests that through full market cycles and across markets the consideration of ESG issues in investment strategies does not negatively impact returns. Indeed, what is interesting is that many of the more recent studies indicate that, if correctly applied, ESG integration can be additive to investment performance.

Much of the analysis undertaken to date has been on global markets, with very little available in the South African context. To remedy this, Old Mutual’s Responsible Investment team tested the MSCI ESG data set for the South African market over the past four years using an approach consistent with similar international studies. While the data set only extends over four years, the results look promising, with highly rated ESG firms performing better than poorly rated ESG firms over the period assessed. These findings are consistent with work undertaken by MSCI on both the global and emerging market data sets over a nine-year period2. We still have much work to do in this regard but we believe the best way to get ahead is to get started.

At present our Customised Solutions investment boutique is already leveraging these insights into our newly launched South African Responsible Equity Index. This work builds on the analysis we undertook in 2015 that supported the launch of the Old Mutual MSCI World and Emerging Market ESG Index Funds (see the article by Kim Johnson on our range of ESG products). Building on this, Old Mutual Equities – our fundamental equity capability – already integrates ESG analysis into its fundamental company analysis and is now exploring the best method to leverage this information in the context of its factor model (see the article from Tracy Brodziak and Leanne Micklewood on the potential to leverage ESG data in the South African market).

CONVERGING FORCES

We see three powerful forces converging which make responsible investing not only a necessary response to the changing nature of global risk and opportunity, but also an important evolution in the role and function of the asset management industry:

1. The myriad of interconnected ESG issues present a material impact to stable, long-term economic growth at a local, national and global level3. Governments alone will not solve these issues and all sectors, including the financial sector, can and must play a role in addressing these issues. Coupled with this, expectations are changing across society as company stakeholders – employees, customers, shareholders, regulators, civil society etc – increase their demands in respect of company ESG performance. In our connected world, how a company responds to these issues will influence its market competitiveness. The good news is that the evidence shows that profitably and low carbon, socially inclusive and resourceefficient growth can co-exist (see Jon Duncan’s article regarding Green Growth).

2. The asset management industry faces an existential crisis as critics question its societal value and push back against fees, while on the flip side there is a growing investor base seeking to align their portfolios with their personal values and make the world a better place4 (see finding from our online survey: What SA’s savers really think about responsible investing). Responsible investment has the potential to serve as a powerful catalyst for realigning the asset management industry with societal concerns while at the same time meeting investor expectations.

3. Lastly, there is a growing understanding that continued short-termism is problematic at a systemic level. Primarily shorttermism undermines future economic growth due to the lack of long-term capital investment, which ultimately leads to slowing GDP, higher unemployment levels and lower future investment returns for savers5 — implications that could hurt everyone. Global asset owners are now turning to responsible investment as a means of driving long-term value creation.

A deep understanding of these secular trends, along with hands-on tangible evidence of the positive value that can be derived from an analysis of material ESG issues, supports our view that responsible investment can and does add value to longterm client outcomes.

1 http://www.hbs.edu/faculty/Publication%20Files/12-035.pdf
2 Can ESG Add Alpha? - MSCI June 2015
3 WEF annual risk assessment survey
4 TIAA Global Asset Management survey of investors and advisers 2016 - Over three quarters (77 percent) of the affluent US investors say that they want their assets to have a positive impact on society
5 Focusing Capital on the Long Term 2015 Report

AUTHOR

hywel
Hywel George
Director of Investments

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