In part two of a three-part ESG series, we discuss with Melanie Griffiths why private clients may wish to consider ESG investing.
Do you expect private wealth to be driving demand going forward?
There are a number of reasons why private clients are increasing their interest in ESG investing - I will look at each of them in turn.
2) Investment returns
3) Positive impact through investments
4) Engaging the next generation
I believe there will come a time when private clients who are not seen as investing ‘responsibly’ will be faced with a reputational risk. This is - similar to tax where the same fact patterns can be looked through a ‘tax planning’ or ‘tax avoidance’ lens - it can be a tight morality line to walk.
It is important to consider however that each family will have a unique history and modus operandi, meaning they face different reputational risk. We all saw the backlash on Meghan and Harry when they used private jets whilst advocating for climate change reduction measures. There could be issues with a prominent mental health philanthropist investing in Facebook (which tends to rate highly on ESG measures) or a Formula One driver specifically excluding oil companies from a portfolio.
2) Investment Returns
Many settlor / beneficiaries seem to fear lower investment returns when investing in ESG. This is misconceived.
It is now well documented that high ‘ESG’ scoring companies performed better during the pandemic because they needed to analyse their supply chains to identify where in the production process they were having the biggest environmental footprint in order to improve their ESG scoring. When the pandemic hit and supply chains were disrupted these companies were able to react faster because they were on top of their supply chains. What is less clear is why it would take an ‘ESG lens’ for companies to be on top of their supply chains - isn't it something that makes sense, irrespective of any ESG considerations? Treating employees well, identifying ways to reduce costly waste, having a diverse board etc. all make good business sense and should be sources of competitive advantage.
I remember the first time I attended an ESG seminar when it started to become more mainstream - as I listened to the panellists, I thought to myself: ‘are things like governance, potential lawsuits etc. NOT looked into as part of a ‘normal’ investment due diligence process? Don’t all investors want to know these things, not just the ESG minded ones?’ The reality is that many thorough investment managers have been incorporating ESG factors in their process long before the term ‘ESG’ was coined, and I suspect there is much frustration among very reputable managers at the way ESG has been usurped as a novel investment thesis.
So, the question becomes: from an investment perspective has anything really changed? Wasn't ESG always integrated to some extent into investor's analysis? I accept that perhaps there was more focus on the ‘G’ than the ‘E’ and ‘S’ but in my mind, there have been two further significant developments:
1. The government's willingness to start pricing negative externalities, writing certain environmental and social commitments into law and developing policies to match (subsidising certain industries, penalising others etc.)
2. The increased public / consumer / media scrutiny meaning that companies, and those who provide services and financing to them, can very easily find themselves at the centre of a very costly public relations nightmares and more recently, costly litigations
This means that ESG can become somewhat of a self-fulfilling prophecy - the direction of travel is such that those companies who do not integrate ESG into their strategy will face higher costs of capital / taxes and will find talent acquisition more difficult which will in turn impact on financial performance. It very much makes sense for investment managers to consider ESG as integral to their securities selection process and a failure to do so could result in lower investment returns.
Of course, supply - demand dynamics can also turn ESG into a self-fulfilling prophecy. Over the last three years, there has been a notable increase in the forward price / earnings ratios of so called ‘halo’ stocks (‘ESG leaders’ which feature in the majority of ESG strategies). Prior to that, they had been trading broadly in line with the market but now trade, on average, almost twice the market multiple, as can be seen in graph below.
Source: Empirical Research Partners Analysis
Such multiple premium could be justified on a number of grounds but looking at fundamental factors such as cash flows and growth, halo stocks don’t appear to be particularly different from the rest of the market. The only difference appears to be the ESG factor which seems to drive the price / earnings premium.
Source: Empirical Research Partners Analysis
Given the demand dynamics, the trend is unlikely to reverse soon but there will come a time when the focus of the attention will very much need to shift to the investment manager's inherent skills. Merely riding the ESG wave will no longer cut it. There are elements of a bubble hidden amidst the major structural shifts dictating an ESG lens on investments.
When it comes to investment returns, I will play devil's advocate by sharing a graph showing how tobacco stocks performed historically - a good proxy for non-ESG friendly stocks. Since the beginning of the century they have significantly outperformed both global index and the S&P500, despite being out of favour. There is some logic to this in the sense that one would expect higher returns to compensate for the reputational risk of holding such stocks.
3) Positive impact through ESG investments
In my mind, the biggest challenge to ESG investing is measuring any positive impact. Analysts look through a company's annual report and other documentation to determine a company's ESG credentials. In other words, many companies self-report on at least part of their ESG credentials. Some investment managers are even using AI to pick up how many times certain key words are included in a company's annual report and marketing material as a way to score a company from an ESG perspective. I know AI is clever and designed to identify discrepancies, but still it seems to me that at the very least there is potential to cheat the system. I struggle to imagine a company with poor governance highlighting in their annual report that they pollute rivers, have not taken any steps to monitor whether there may be child labour used along their supply chains or that they actively encourage addiction to certain foods and medical drugs.
Although there are many attempts to rate companies according to their ESG credentials, there are no universally agreed ones. Tesla would be an example of a name that could feature high on ESG scoring if looking at the ‘E’ but low if looking at the ‘G’. The correlation scores between the ESG ratings agency is low (60% vs 98% for credit score agencies (Moody's, Fitch, S&P)) - in other words the ESG ratings agencies don't agree on what good looks like, meaning a particular name might outperform or underperform whilst rating high on Morningstar's ‘Sustainalytics’ but low on MSCI ESG ratings.
The table below illustrates the disparity between ESG scoring agency for some well-known tech stocks.
Source: Compiled using Bloomberg, accurate as of June 2021
One of the reasons many of our settlors / beneficiaries walk away from ESG investing is that it does not match their expectations in terms of values. A large retail investment platform recently announced their top five ESG picks which included Coca-Cola and British American Tobacco (BAT). To someone who feels passionate about having a positive impact on people and the planet, it might be a shock to see BAT and Coca-Cola in their portfolio. As sustainably as they grow their crops, as fairly as they treat their workers, there is something that may not resonate with those who feel passionate about having a positive impact. The bottom line is these companies' products are perceived as having a negative health and environmental impact even if they may be produced ethically.
Ultimately, investment managers tend to focus on the impact of climate change etc. on companies (in terms of insurance and legal costs, disruption to supply chains etc.) whereas private clients who feel passionate about ESG tend to care about the impact companies have on people and the planet. In other words, investment managers / scoring agencies tend to focus on the way goods and services are brought to market (i.e. the production side of things) whereas those who feel passionate about ESG tend to consider the impact of a product and service on the environment and society (i.e. the consumption side of things). This means that there can be a complete misalignment in terms of expectations.
Many families are now wanting to move beyond how ESG risks affect the risk-return profile of their investment’s portfolio, leaning more towards thinking about how their portfolio impacts on society.
4) Natural anchor to engage the next generation as wealth transitions
I believe one of the greatest benefits of ESG is that young people are very engaged with the issues - it is crucial that the momentum is leveraged, and the energy harnessed to positive effect. It is the first time in a long time that young people - collectively - feel passionate about something. At a time when religion is less prominent, families and communities are not as strong as they were, politics has lost much of its appeal, the environment, climate change and social justice have become building blocks to the younger generation's sense of identity. In many respects, the younger generation has caught on that, as a collection, they may have more power to initiate change via the way they consume and invest rather than through political affiliations.
Environmental and social sustainability is a natural anchor point for the younger generation to become involved with the family’s affairs, whether it be in business operations or investments. If nothing else, it means they become more interested in how the wealth is generated and invested than they might otherwise have been. Even more important though, it is a natural point for them to contribute and bring something to the table. The potential for ESG to unite family across generations should be celebrated and nurtured.
In the third and final part of this series, I will share some thoughts for families wanting to embark on a journey to invest sustainably and responsibly (or review their existing framework). If you haven't already, read Part I of the ESG series here.
This article has been carefully prepared, but it has been written in general terms and should be seen as broad guidance only. The article cannot be relied upon to cover specific situations and you should not act, or refrain from acting, upon the information contained therein without obtaining specific professional advice. Please contact Equiom to discuss these matters in the context of your particular circumstance. Equiom Group, its partners, employees, and agents do not accept or assume any liability or duty of care for any loss arising from any action taken or not taken by anyone in reliance on the information in this article or for any decision based on it.