Let’s start with the easy part: strategies that only apply simple exclusions and are still labeled as being sustainable should be a thing of the past. Investing sustainably is also much more difficult than buying a set of ESG scores and applying it to a portfolio. There is more to sustainable investing. Let’s talk about the new ways of sustainable investing, and the ‘greenwashing’ dilemmas.
There are clearly areas that sustainable investors want to avoid, such as tobacco, weapons, breaches of labor standards and human rights, and certain types of fossil fuels like thermal coal. Other areas are less clear. Traditional fossil fuels, for example, are a big contributor to climate change. However, they are still widely used and needed. There are those who believe that energy companies are both part of the problem and the solution. Others simply want to avoid them. The question is whether being invested in those companies and engaging with them might be a better way of creating change than avoiding them all.
Secondly, in my opinion, a strategy is only sustainable if it is also financially sustainable. So, integrated thinking is important. How do long-term ESG trends and external costs such as climate change, loss of biodiversity and rising inequality lead to changes in business models? ESG investing no longer means only reducing an investment universe to the ‘best-scoring’ names. It means thinking hard about sustainability and how it affects companies and investment strategies. To give an example: in all our quantitative strategies, if two stocks have equal (financial) factor scores, the one with the better ESG score will have a higher weight. In our fundamental strategies, ESG will affect the valuation, i.e. the target price. For example, data privacy and its management thereof by internet companies was already priced into the valuation model long before this became an issue. It’s the same with the health care sector and pricing.
Structurally integrating ESG information into the investment process helps our teams make better decisions. It does not, however, reduce the universe, and they are still allowed to invest in companies with low ESG scores so long as they believe the risks are more than priced into the market. In our global equity fund, we saw that over the last two years, about 75% of valuations were adjusted after factoring in ESG criteria. This ESG integration combined with the exclusion of tobacco and controversial weapons contributed about 22% of the outperformance seen over the 2017-2018 period1. This method of integrating ESG, although infinitely more difficult and profound in its application than only using ESG scores to reduce the universe, is often not categorized as a sustainable strategy. Clients who want to invest in sustainable strategies simply do not want to invest in ‘bad’ ESG companies, even if this is already reflected in the share price.
Resources and research
Now, this all requires dedicated resources and research. If you ask an investment team to add ESG to their process, you need to give them the resources and knowledge to be able to do so. They did not get this stuff at university or in their on-the-job-training most of the time. At Robeco, we have many different sustainability specialists working with all the investment teams, and we do not have a separate sustainable investment team. Everyone participates. There is also a wealth of ESG data around, so being able to understand and judge this data is most important.
Let’s use another example to explain, by comparing the carbon footprint of two mobile phone companies. Imagine that one company has outsourced all its operations, while the other is vertically integrated. The first one has a low carbon footprint and the other has one that it is much higher. This is an illusion: of course, making a mobile phone creates more or less the same carbon footprint. This is not visible in the data, but requires knowledge and judgement to see that it is there. If you have no resources committed to looking at this, and analysts do not have access to sensible research or an understanding of these issues, you will not be able to structurally integrate sustainability.
Another way of implementing sustainability is through Active Ownership. At Robeco, we have been an active owner for 15 years. We have a very structured approach in tackling themes that other investors are not even thinking of yet, such as engaging on data privacy in 2015. This year, we are starting to engage on digital healthcare and the social impact of artificial intelligence. Both themes are very much forward looking and related to both new technologies and sustainability issues: the first aiming to tackle rising health care costs, and the second looking into the social risks that might occur in the long term.
Last year, our team of 13 dedicated specialists engaged with 214 companies. The engagement takes place over a three-year period, allowing us to track and measure the progress of companies. Some asset managers claim to engage with 2,000 companies per year. In my opinion, that cannot be more than asking one or two questions on ESG at a regular meeting, or sending a standard letter. You need to have substantial resources in place to be able to do this in a credible way.
Voting behavior is also interesting. Research shows that some of the larger (passive) investors almost always vote with a management’s recommendation, even on shareholder proposals relating to environmental and social issues. That doubts the credibility of that manager, I think. We see that social and environmental shareholder proposals are becoming better formulated and more in line with long-term shareholder value creation. So, last year we voted in favor of those proposals in 72% and 78% of the cases, respectively.
Walking the talk
This brings me to my key point: walking the talk. How credible is a fund provider if they provide a few very good SI funds, but are not doing anything in their other products, or in their own operations, such as the voting behavior I mentioned earlier? There are many questions that clients should ask to determine credibility. Another interesting resource is the PRI Asset Owners manager selection guide.
Lastly, a quick word about labeling. They could provide valuable guidance and a stamp of approval for a fund, which would be good for retail investors. Current labels do differ in their approach though. That is most likely because approaches to sustainability investing differ so much. The French SRI label, for example, focuses more on the investment approach, process and transparency. It is externally verified, so you really have to show that you have the right data, processes and procedures in place to obtain the label. The Belgian label is much more prescriptive, specifically on what not to invest in.
However, even this leaves a lot of room for maneuver, and asset managers still need to do their own research. If you need to exclude an electricity company that does not comply with the Paris Agreement, how do you calculate that? So, even with labels, there is a lot of room for debate. Transparency is most important: asset managers need to clearly show what is and what is not part of the strategy of the fund, no matter whether it is called sustainable or responsible, or something else.
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1 Source: Robeco Global Stars Equities fund performance figures.