In the third and final instalment of a three-part ESG series, Melanie Griffiths summarises the key considerations for ESG investing from a private client perspective.
What should families wanting to invest responsibly think about?
Firstly, investment managers should not drive the responsible investing agenda- it is very much the family's prerogative. The approach needs to be tailored to each family according to their background, values, the impact they want to have and how involved they want to be. Any manager who is serious on the responsible investing front will be able to work with a family to tailor the approach. If they only have an ‘off the shelf’ ESG solution, then it is likely that ESG is integrated into their selection process but with an investment focus rather than an impact focus.
I would then consider the following:
A) Establish the strategy and incorporate in the governance
Responsible and impact investing should very much be a ‘top-down’ approach from the family. A family needs to establish what matters to them, what they care about, what they value. Is it plastic, biodiversity, access to water, climate change, gender equality, racial equality? It is important to discuss as a family what these things mean to each member of the family, so as not to end up divided and less effective later.
No one is against ‘sustainability’, but there are diverging views as to how to achieve this. Broadly speaking, it very much depends on how one views nature (which in itself may depend on one's religious views). At one end of the spectrum, there are those who believe nature is perfect and human interaction throws nature out of balance. At the other end of the spectrum, there are those who believe nature is imperfect, sends us floods and diseases, and our role is to improve nature through science and technology. While there are lots of nuanced views in between the two ends of the spectrum, the former camp tends to advocate for less consumption and holistic / natural approaches (e.g. organic farming), the latter camp tends to advocate for technology as the way forward (e.g. lab grown meat etc.).
A family may agree that they want to support a transition to a carbon neutral future through their investments, but they may not all agree on the way to achieve that – some might herald electricity as ‘green’ while others highlight that much electricity is powered by nuclear which creates very problematic waste, that the batteries required to store renewable energy require rare earth minerals often extracted using child labour etc. Some might prefer hydrogen as a greener source of energy while others may prefer to focus on ways of living which reduce energy consumption regardless of the energy source (e.g. living accommodation with common kitchens, laundry rooms etc.) The most effective strategies will likely approach an objective from several fronts and might include a mix of ESG investing, impact investing and philanthropy.
Responsible and impact investing needs to be part of the family’s DNA. It should be the reflection and ultimately implementation of the family’s values. Family governance documents such as family charter, investment policy statement, letter of wishes etc., should reflect the family’s commitment but ultimately, the family needs to live and - want to - live the commitment.
B) Get the right advisors on board
I recently made enquiries into making our house more energy friendly. I wanted to look into various options (solar panels, heat pumps etc) and undertake a cost-benefit analysis. Our builder had previous negative experiences and tried to dissuade us at every stage without much constructive discussion. I gave up on the idea until I was put in touch with someone who really knew what he was talking about. As it happens we decided against many of our plans (not all!) but it was an informed choice, we had access to the information we needed, we were able to lean on someone we trusted and who had the integrity to tell us when something did not make economic sense. One doesn't need advisors who are experts on ESG, but one does need advisors who are on board, ask the right questions (including the challenging ones!) and are committed to leverage their network and cooperate with other advisors as required.
C) Distinguish between a company’s impact and an investor's impact
If an investor is only selecting ESG ‘green stars’ then arguably that investor's impact is very little - it is the companies that are having the impact, not the investor. Families should assess where they may be most impactful taking into consideration their background, expertise, network. We recently had a family who, having reviewed the ESG investment landscape decided to take a distribution for philanthropic purposes - they thought they could have a bigger impact this way than through investing in ESG focused funds.
D) Establish an implementation route
When it comes to implementation, there are many factors, other than ESG, to consider such as liquidity requirements, time horizon, how involved and how much time does the family want to dedicate to this. What expertise is available within the family and how will those investing time in ‘making an impact’ be acknowledged for their contribution versus other family members involved in running the family business and assets? Answers to these questions will determine whether to appoint an investment manager, invest via the public or private markets etc.
In my opinion, exclusionary strategies (i.e. excluding certain sectors such as Tobacco) achieve very little in terms of impact (this is also backed by empirical research). It is very legitimate to do so because of one's personal values and beliefs but not engaging rarely achieves much in terms of change. In fact, it may worsen outcomes. A number of companies have been looking to offload part of their businesses (e.g. a polluting plant) to improve their ESG scores; these assets often end up being bought by investors who do not have ESG in mind. There will always be unscrupulous corporates out there. While many ESG strategies outperform, so do many ‘vice’ funds (funds investing in sectors such as tobacco, alcohol, arms, gambling etc). One must also consider that the companies best placed to drive meaningful change are those with the scale, resources, manpower, footprint and longevity – the Shell and BP etc of this world.
Empirical evidence suggests that in the public markets, impact is most likely to be achieved through stewardship. In other words, what is most valuable is how shareholders vote. Such an approach support companies to transition to higher environmental and social standards. Therefore, if investing via a manager, due diligence must be done on how they use their voting rights. How have they voted historically e.g. have they voted in favour of ESG positive resolutions? Do they outsource voting to a proxy voting agency? Do they sometimes collaborate with other institutional investors to support ESG positive resolutions? There may be an argument to be made that the largest fund managers with the biggest holdings will potentially have more weight in stewarding the company in the right direction - that needs to be balanced of course with the manager's investment strategy / track record etc.
In terms of active versus passive, it's currently a debated topic in the investment management industry. Intuitively, one might favour active managers over indexes thinking they are better placed to select companies with a positive impact. One must remember, however, that active managers always have the option to exit an investment in a company if they think the company's ESG credentials are likely to impact on performance or the manager's reputation. Passive managers meanwhile have no choice but to remain invested and so can only influence a company through their stewardship, meaning it is in their best interest to keep a razor-sharp focus on stewardship.
Meanwhile, when it comes to the private markets, to achieve greatest impact as an investor one must invest in sectors where capital is scarce - the investor's impact will be very limited if investing in companies who have plenty of capital available (as impactful as these companies may be). The markets are not well geared to allocate capital to very long-term investments, and one may have to give up some liquidity to maximize impact as an investor.
E) Ask any investment manager being considered - what are their own ESG credentials?
Ask them what ESG due diligence they do on the companies they invest in and ask them the exact same questions for themselves - what is their purpose, carbon footprint, gender pay gap etc?
F) Compare prices between ESG and non-ESG equivalent strategies
The iShares S&P500 Paris Aligned Climate ETF costs over three times as much as the iShares S&P500 ETF. There may be very good reasons for the higher charges, but it’s important to understand what drives any price difference and that it reconciles to the manager's stated strategy. If ESG is integral to the investment manager's strategy, then it is hard to see that it would dictate additional costs. If there is an ESG team which reviews the investments through an ESG lens, independently of the investment lens, then one would expect higher costs. It is important to bear in mind however that higher costs will ultimately impact on performance and there comes a point when it might make more sense to engage in impact investing if one is giving up returns.
G) Ensure sight of investment performance is not lost and review the overall investment strategy to make sure it is still sound.
As a client once told me when reviewing an opportunity with seemingly limited potential to make money: ‘I’d rather gift the money than invest - I prefer to be seen as a generous benefactor than a foolish investor.’
i) Investment performance
I often hear trustees, beneficiaries and settlors citing lower investment returns as a reason to be cautious with ESG. The problem may not so much be ESG, as the investment manager's skills. Investment managers are very good at explaining away underperformance: it’s the USD, the EUR, the hedge funds who didn't perform how they were supposed to, the greater correlation than expected between asset classes, the retail investors disrupting the markets etc... and now ESG can potentially also be offered as an explanation for underperformance.
As responsible investing can be something very close to a client's heart, it can be easy to invest 'with the heart', be seduced by the story / potential impact, but it is important to remember ESG is not philanthropy and thorough due diligence should be done on the investment side of things (track record, volatility, diversification etc).
Liquid / ESG strategies should not result in lower returns. With illiquid /impact investing, there may be a trade-off between returns and impact, but one should be clear at the outset exactly where on the spectrum one is investing, how much returns - if any- are being given up for what additional impact.
ii) Investment strategy
Is the risk and liquidity profile still aligned to the family's requirements? The general recommendation is that no more than 20% of liquid wealth is held in illiquid assets and no more than 2-3% in any single illiquid investment.
It is important to be aware that there is a wide consensus amongst ESG managers as to which companies are good from an ESG standpoint and which are bad. In other words, they tend to be overweight the same companies (e.g. renewable energy) and underweight the same companies (e.g. oil producers). This means that private clients who allocate a high proportion of their overall wealth to ESG managers could find themselves with high hidden concentrations. While an investor may feel well diversified through investing in lots of fund managers, it defeats the purpose if all the fund managers are invested in the same underlying companies. It is therefore important to do an analysis of the top holdings across managers across the portfolio.
...and to take it to the next level?
The above are suggestions to get started on the sustainable and responsible investment journey. Families who are farther along the journey / have the required buy-in and resources to dedicate to their commitment are re-thinking the way they invest altogether. They are building their portfolio around the United Nations' Sustainable Development Goals (UN SDG), moving away from measuring investment returns and moving towards measuring impact. Rather than focusing on the risk of climate change, loss of biodiversity etc on their portfolio and how it may impact on the risk profile of their investments, they are concentrating on what impact they are making through their investments on society. In other words, they are thinking like ‘universal owners’. With the UN SDGs as the focus, it becomes easier to have a strategy guiding investments across liquid and illiquid asset classes.
Such a strategy also reduces the reliance on the ESG ratings agency, which may turn out to be a sound from an investment perspective. As was seen with Boohoo and other recent scandals, the agencies tend to downgrade 'after the event' which suggests they are not a good radar. Over reliance on the dispersed ratings could backfire. As Andrzej Janiszewski commented in the FT last November: ‘the danger of over reliance on labels is very reminiscent of the trust placed on credit ratings prior to the last credit crisis.'
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.