TWO GLOBAL MEGATRENDS CONVERGE
The prominence of the Principles of Responsible Investment (PRI) has grown tenfold as evidenced by the number of signatories and assets under management (AUM), which, as of April 2017, were 1 700 signatories, representing US$62 trillion in AUM1.
This has prompted investors to increasingly look at ways of incorporating Responsible Investment (RI) approaches into their investment strategies. For example, MSCI currently has US$58 billion in assets benchmarked to their range of ESG indices2 and is the world’s largest provider of environmental, social and governance (ESG) indices3 and research.
Index investing has similarly become a global megatrend as investors increasingly recognise the benefits that low cost index funds can offer to their overall investment portfolio.
THE FOUR CATEGORIES OF RI INDICES
At Customised Solutions we understand the emergence of RI indices and have seen them evolve into the following four categories:
- Best in Class > ESG scores are used to select companies that best manage the long-term risks affecting their industry, while being cognisant of the parent index to limit systematic risk.
- Screen Exclusions > This approach excludes companies involved in certain business activities (e.g. alcohol, gambling, coal, etc.) to achieve their objectives, and includes those with ethical, moral or faith-based investment strategies.
- Resource Efficiency > With humanity’s ever-growing demands on the Earth’s natural resources, increased pressure to respond to climate change and limit pollution, companies that use fewer resources and produce less waste in the production of their goods and services are identified to create an index with an increased resource efficiency score relative to the parent index.
- Green Growth Impact > To address the risks of climate change, resource depletion and environmental erosion, companies are classified according to a green economy taxonomy, which facilitates the creation of indices not previously possible with traditional sector and industry classification frameworks.
Old Mutual’s Responsible Investing Equity Index Fund has adopted a best-in-class approach to ESG investing. We believe that this offers investors an optimal trade-off between taking a strong stance on ESG issues to mitigate against the long-term risks within each industry, without introducing significant systematic risk relative to the market.
THEORY ASIDE, LET’S TALK ACTUAL PERFORMANCE
With a full year of actual performance behind the Responsible Investment Equity Index Fund, we unpack what has been driving its outperformance (as seen in Chart 1) relative to its parent index, the FTSE/JSE Shareholder Weighted Index (SWIX).
The biggest contributors to the Fund’s forecast tracking error relative to the Shareholder Weighted Index (SWIX) originate from the best-in-class ESG selection approach, as well as sector tilts introduced through this process. While the Fund aims to neutralise sector tilts arising from the screening process by selecting the top 50% of companies from an MSCI ESG Ratings perspective within each sector, this is not always possible, as indicated in the factbox.
What causes sector tilts when screening?
- Number of companies within a sector
- Size distribution of companies within a sector
- Number of companies eligible for inclusion
- Secondary effects from other sector tilts
THE IMPACT OF CONTROVERSIES AND POOR ESG RATINGS
In extreme situations, it is theoretically possible for all of the companies within a particular sector to be excluded from the Fund if they have been involved in severe controversies or have had very poor ESG ratings. While not affecting every company, such a situation has recently arisen within the Materials (more commonly known as Resources) sector. A number of prominent South African gold mining companies are liable for the class action lawsuit brought against them by former workers now suffering from various lung diseases, including silicosis and pulmonary tuberculosis. The companies implicated in this severe health and safety controversy include Anglo American, AngloGold Ashanti, Gold Fields, Harmony and Sibanye Gold, with claims dating back as far as 1950. Indications are the claimants will receive settlement amounting to about R450m by the end of 2017, a fraction of the R10bn liability it could have cost based on a 2009 paper published by the University of Witwatersrand and University College London. BHP Billiton, Glencore, Impala Platinum, Lonmin and Sasol are also ineligible for inclusion in the Fund due to controversies and/or low ESG ratings.
While the underweight exposure to Resources relative to the SWIX contributed to outperformance, the stock selection within the Resources sector contributed almost four times as much outperformance, which highlights the benefits of selecting companies that better manage ESG risks relative to their peers.
Beyond the Resources sector, Steinhoff was the biggest contributor to the outperformance of the SWIX by not being included in the Fund (due to a lower MSCI ESG Rating) than its peers in the Consumer Discretionary sector. As of 30 April 2017, it lagged the market by a one year total return of -20.84%, which caused the outperformance.
The main reasons for its lower score are primarily due to issues pertaining to labour management and chemical safety, among others. It has also been flagged for controversies relating to bribery and fraud within the Governance category. German authorities raided its offices in November 2015 to investigate possible overstatement of sales that were reported as income in intragroup sales.
WAIT, THERE’S SOME DETRACTION TOO!
It would be remiss of us if we neglected to highlight where value has been detracted over the last year. Not all positions in the Fund selected or excluded based on ESG criteria, will always contribute to outperformance, especially over the short-term. Within the Telecommunications sector, MTN detracted the most value from the Fund relative to the SWIX. There are only three securities in this sector, with MTN dominating in terms of size relative to Vodacom and Telkom, and it will therefore be included in the Fund to meet the 50% sector coverage requirement, unless it is ineligible due to a severe controversy. While MTN lagged the market over the year, the value it detracted was more than offset by the other stock selection decisions.
Responsible investing is very much a long-term global theme, which makes evaluating its performance over a short period almost contradictory. That said, the Responsible Investing Equity Index Fund aims to balance the objective of investing in companies that are better for the planet (environment), better for the stakeholders who interact with the company (social) and place greater emphasis on best practise from a governance perspective (governance) while being cognisant of the systematic risk relative to the overall market.