Insights

As we trundle into 2019, there are some meaningful changes in the world’s thinking about responsible investing. View a quick overview of the article by Andrew below.

WRITTEN BY: Andrew Canter, Chief Investment Officer

“In economics, things take longer to happen than you think they will, and then they happen faster than you thought they could.” 
Rudiger Dornbusch

Tipping Points: There are some long-standing trends that may be on the cusp of reaching concurrent tipping points:

• The World is Heating Up:  Global warming itself could genuinely be approaching the point of no return – with visibly rising temperatures, melting ice, and altered climates. The ability to plan for the future has dropped from decades to mere years. Time for consideration of the necessary changes in humanity’s behaviour is becoming short.

“The cost of not acting on the SDGs is becoming higher than the cost of acting.”
Paul Polman (Unilever)

• Investors Know the World is Heating Up:  Until now, humans have been willing to trade 'ecology' for 'economy'.  Asset owners and fund managers are now embracing a meaningful, large-scale change in the way they view carbon (or pollution) emitting investments. The shift of capital away from carbon emitters will increase those companies’ cost of capital, and hasten those industries’ relative decline. 'Stranded assets', a phrase first coined only a few years ago, has quickly become a real factor in company analyses. Further, the technology revolution is delivering large-scale investment opportunities in a more green economy (e.g. alternative energy production and storage).
  
  This is not an argument against jobs, but rather an argument in favour of a different set of jobs and growth drivers: It takes construction to build alternative energy sources, and employees to maintain and operate them.

“The sustainability revolution has the magnitude of the industrial revolution but the speed of the digital revolution.”
Al Gore

• Political Risk has Risen:  Inequality, slow growth, corruption and mismanagement have created political risk, such as the populist backlash against 'the status quo'. Capital owners (investors) invariably represent the 'status quo', and thus face risks of uncertainty, expropriation, taxation, and protectionism. Investors’ move to channel capital toward development, and to be more responsible, is both appropriate and defensive.
  
  The UN’s Sustainable Development Goals (SDGs) are 17 broad parameters to measure human development in the period up to 2030. Investors seem to be embracing these as one possible set of measures for successful impact investing.

“If you are aware of a crime, and do nothing, then you are part of that crime.”

Time for Change: Some overdue changes in the fund management industry may be in the offing:

• The Rise of Purpose:  The growing trend by industry participants to seek a sense of purpose is a positive development. Once investors move beyond the simplistic goal of “making money” toward “making money and being a positive force in the world”, we take on a wider role and duty, and that demands more varied analyses and better decision processes. Culture is a competitive advantage in building robust decision processes, but also in attracting clients and employees.
  
  All investors should seek top returns, but just as a parent must feed, clothe, educate and nurture a child – and do all of them well – so investors must seek returns while being a positive force.

“Millennials will be 75% of the workforce by 2025: Demographics is a friend to culture change.”

• Active Ownership Tools:  Investors globally are finding new tools to be responsible and engaged investors. This includes such things as proxy voting policies and reporting, direct dialogue with companies, a range of national 'stewardship codes', and improved reporting on sustainability issues.
  
  
• The Veneer of ESG:  Asset owners and consultants are awakening to asset managers’ using ESG as a sales tool and not necessarily as an investment process. Asset owners are suitably skeptical, but are learning to differentiate between 'ESG on the label' versus 'ESG in the product'.
  
  
• ESG Factor Reporting:  There is global movement toward requiring more comprehensive and standardised reporting on a range of ESG factors.  Companies regularly issue standardised financial accounts for analysts’ interpretation. Likewise, improved information flow on Environmental, Social and Governance (ESG) factors is a vital first step for analysts to do their work. A good example is reporting on a company’s net carbon impact, their own 'internal price of carbon', and their own views of risks arising from ESG issues. However, presently there is a lack of standardised, consistent, high-quality data coming from issuers.

“Sunlight is the best disinfectant: More comprehensive ESG reporting to engaged, diligent and independent analysts will mean more sunlight is shone.”
Andrew Canter

• People Lie, Monopolies Exist:  The world is more awake to the reality that people don’t always tell the truth, and are sometimes active and unapologetic liars. Investors have often been willing partners in the stories told by company managers, in favour of rising share prices. Further, it is clearer now that industries are seeking – and winning—market dominance and monopoly powers. Lying, manipulation and self-serving are certainly not new, but our growing awareness of this could lead to backlashes from governments, competitors, regulators and investors. Humans have built complex societies and economies based on trust: But trust is being broken, and we are shifting toward a new equilibrium where we 'trust but verify'. Humans have inherent biases to believe 'everything will be alright' and 'he’s telling me the truth' – but perhaps the scales have fallen from investors’ eyes about the actions, motives and practices which we must more cynically assess.
  
  
• Deepening Responsible Investing:  In South Africa, recent history of both corporate and public sector shenanigans, plus the rising tide of the PRI, CRISA, and Reg 28, has led retirement funds, consultants and asset managers to contemplate how they can broadly improve governance standards.  The King IV Code, for all its merits, is evidently not a panacea.  Some ideas to improve investors’ role in corporate behaviour might include:
  
  
  • Reducing Benchmark Cognisance:  Equity managers and their clients tend to fetishize their benchmarks, and seek to maximise returns while minimising 'tracking error' against a broad-market index. This encourages asset managers to be 'closet indexers' or 'benchmark huggers' – reticent to stray too far from benchmark exposures. Thus, a manager with a strong view (either financial or ESG based) has a very difficult time going to 0% exposure of a large-cap share. Indices indiscriminately include all issuers with certain size characteristics – without regard to their sustainability. Until asset owners (i.e. clients, investors) expect and encourage more bold positions (relative to benchmarks) – and sometimes accept performance that deviates from flawed benchmarks – asset managers will be reticent to act strongly on their analyses, or listen fully to their inner voices about corporate misbehaviour
    
    For example, even if an equity manager had strong suspicions about Steinhoff, he would have been unlikely to entirely remove such a large cap share from his portfolio. Had he held 0% exposure from, say, 2008, then his clients would have felt he’d been 'wrong' for ten years, before finally being 'right' in 2017.
    
    
  • Stronger Standardised ESG Reporting:  See above
    
    
  • ESG Ratings:  ESG analysis is a complex and expensive process, and there is space in the market for third-party ESG analysis and a rating process. While I would never advocate for an investor to abdicate decision responsibility (e.g. to rely on an ESG rating agency or a credit rating agency), such agents can provide a standardised framework and reporting on ESG issues, and be an input to one’s own analyses and decision processes.
    

    “An ESG score is a starting point for a conversation.”

  • Analytical Independence:  Investment analysts are subject to a range of inappropriate pressures which impair their independence. For example, there are corporate bullies who will exclude analysts who make critical comments or issue 'sell' recommendations on their shares from future conference calls or report backs. There are employers (e.g. banks) or shareholders (e.g. insurers) who are more interested in protecting their corporate relationships than allowing analysts and portfolio managers to work in an unfettered manner. Such interference happens – either overtly or subtly – with some frequency. South Africa has seen strong evidence of the protection offered by a free press, and investment analyst independence is equally vital in maintaining accountability and transparency on issuers in public capital markets. The mindset that “governance begins and ends with the Board of Directors” is well entrenched, despite a more sophisticated view that governance is the duty of the Board, insiders, capital providers (investors and funders), regulators, auditors, journalists, and customers.

“It is a great sin that the broad investment community – asset managers, investment consultants, retirement funds, and industry bodies such as ASISA, the Investment Analysts Society, and CFA South Africa – is universally and consistently silent on the topic of analytical independence.”
Andrew Canter

Coming Soon? There are some ideas whose time has not yet arrived:

• ESG is a Tool for Better Investment Decisions:  Many asset managers see ESG as ancillary to their analysis or a mere screening tool for investments (e.g. negative screening). Rather, ESG factors should become an additional set of analytical tools on which to formulate investment ideas and identify material risks or opportunities – and thus build top-performing, competitive investment processes.
  
  
• Returns versus Being Responsible:  Investors must seek returns as a primary goal, and there should be no compromise of investment returns in favour of social or developmental impact. Sadly, many investors still muddle 'ESG', 'Responsibility' and 'Sustainability' with compromised returns. On the contrary, the additional analytical tools of ESG should serve to either reduce risks or increase returns over just about any time horizon. Once the language of asset managers and analysts clearly shifts to risk-avoidance and return-seeking we might see the end of the muddling.
  
  
• Update Risk:Return Tools:  Risk measures of assets and portfolios often include volatility, macro factors, industry factors, and such. Investors need a more comprehensive set of risk measures so as to demonstrate that ESG analysis produces superior risk-adjusted returns. It should be clear that by avoiding governance, environmental and social pitfalls, an investor can reduce portfolio risk (albeit also missing out some high-flyers, before they come to earth) over the long-term.
  
  
• Tick Box Assessments Are Not Adequate; Analytical Judgement is Necessary:  Each company, industry and country might have its own ESG factors, and so it is hard to standardise data and analysis. Thus, many analysts favour a 'tick box' approach to ESG assessments – using a scorecard, rather than applying necessary critical thinking to each factor and each investment. In governance, for example, it is easier to assume the “the Board is watching” when in fact we have the tools and methods to critically assess, and buttress, corporate governance far beyond the Board of Directors.

ESG Hostile?

• #FeesMustNotFall:  Asset owners and their consultants persist with the view that asset management fees are too high, and must be trimmed. While possibly true in many sectors and firms, an investment process that incorporates a range of screening, analyses and tools – and acts in a genuinely competitive way (i.e. seeking returns) while concurrently seeking to be a positive force in the world – is not infinitely scalable, nor is it low cost-cost fund management. If investors want more analyses, more reporting, and generally better outcomes, then fees should not be cut willy-nilly.
  
  
• Is ESG a Political Movement?  Many ESG issues – such as climate change (e.g. coal), gun control, health insurance, and even the UN’s 17 SDGs – have strong overtones of political agendas and social re-engineering. There is a danger that particular political views – personal beliefs, factional interests – can come to dominate ESG analyses and undermine objective measures of human and economic development. Asset owners are probably wary of this risk, and guard against their assets being used to effect social change rather being primarily risk:return cognisant.

Conclusion
The world of responsible investing has seen clear forward movement – at the very least an understanding that the choices about capital deployment have real-world consequences. To overcome the structural barriers to change investors should start by recognizing that ESG factors actually do impact risk:return considerations, and that value-adding investment processes can be built around that idea.

Additional Notes from PRI Conference 2018 (San Francisco) and General Investment Themes

• Recognition of the enormous potential impact of climate change is now embedded in thinking. Mark Carney’s speech “Breaking the Tragedy of the Horizon” (9/2015) is an excellent and reasoned introduction: He notes that once climate change becomes a defining issue (e.g. it is evident) then it may already be too late.
  
  The PRI published a report “The inevitable policy response to climate change” during 2018. The PRI is aware that the longer the delay in climate policy action, the more forceful and urgent the policy will inevitably need to be. It is for this reason that the PRI is supporting the development of a body of work on an inevitable, rapid and forceful climate policy response to help institutional investors take action and implement processes to build resilience across investment portfolios, now and into the future. The report highlights the gap between actual emissions and policy ambitions to reduce them.
  
  
• The UN’s SDGs are complex, but are an interesting framework for reporting on fund impact.
  
  
• The broad themes from the PRI conference echo Larry Fink, President of Blackrock, in his open annual letter (2018), which is worth reading.
  
  
• In the United States, public equity markets are shrinking – from over 7 300 listed companies in 1996 to 3 700 in 2016. This leaves a large pool of capital chasing a shrinking universe, and may well be a driver to higher PE ratios (valuations). This is a further entrenchment of the 'wholesale' (private equity) versus 'retail' (listed market) nature of investments – where professionals can play on one field, while retail investors (and their fund managers) are forced to play on another. Michael Mauboussin's article is worth a review. 
  
  
• Driven by acquisitions and the rise of service (e.g. tech) firms, intangible assets have become a much larger portion of the world’s balance sheets. Previously, it was common to discount intangibles, but in modern parlance intangibles often represent the present value of prospective cash flows. From a lending point of view, this should lead to more analysis of the ability to service debt as a credit metric, but probably lower estimated recovery rates upon default.
  
  
• In many ways, the PRI conference seemed like an echo-chamber of “the converts preaching to each other” and ESG salesmen pushing products. But one of the most interesting panels was “How is Technology Shaping Responsible Investing”. In particular, Debbie McCoy (Head of Sustainable Investing and Systematic Active Equity at Blackrock) was remarkably forthright and informative about the access to, and use of, data/research and analytics – and how to use AI to screen volumes of information to be useful for analysts. For Ms McCoy’s comments alone this entire session is worth watching.

“Information [AI] is only as good as the extent to which the past is predictive of the future.”
Debbie McCoy

“Find smart, great human ideas – and lever technology to test those ideas.”
Debbie McCoy

Local Market Developments

During 2018 we saw two important initiatives which supports a global trend to improve sustainable investment practices in South Africa:

• We saw a shift towards improving ESG reporting for pension funds in South Africa, with the Financial Sector Conduct Authority (FSCA) calling for comments on a draft directive. The directive promotes improved sustainability reporting and disclosure requirements for pension funds. The aim of the directive is to monitor compliance of ESG in accordance with Regulation 28 of the Pension Funds Act, to promote improved reporting and disclosure on non-financial issues.
  
  
• National Treasury is steering policy discussion around defining what sustainable finance is in the context of South Africa. They convened a working group to develop a framework document on sustainable finance. The draft Sustainable Finance discussion paper outlines the impact of ESG risk on the safety, soundness and stability of the financial sector.

*Incorporating notes from the UN Principles of Responsible Investment Conference (9/2018)