How investing sustainably needs active managers to make the world a better place and investors richer

Investors concerned about sustainability should understand clearly what they expect from their portfolio – and know what their chosen investment product is delivering. An active manager engages deeply with a limited number of companies to understand the sustainability risks in their business models. This gives a very different outcome to a process which depend entirely (and simply) on ESG ratings.

“The stock market is a giant distraction from the business of investing.”
John C. Bogle, Founder, Vanguard Group

Can passive funds be managed responsibly?

Industry sources claim that over 40%¹ of the Australian funds market is managed responsibly, of which one third² is managed passively, using ESG ratings, and two thirds actively.

Lies, damned lies, and ESG ratings

Investors should ensure their sustainability expectations are aligned with what a product can be reasonably expected to deliver. A process which depends entirely on environmental, social, and governance (ESG) data – without critical analysis – invariably has its limitations. This may lead to an investor allocating to a fund whose sustainability qualities fall short of what they expect.

• ESG ratings from competing suppliers suffer from a lack of standardisation, varying far more than credit ratings issued by leading agencies. This is not to question the integrity of any process, but different providers prioritise quite different risk factors. This creates the temptation for companies to ‘shop around’ for the highest ESG rating.
• ESG data tends to be incomplete, especially regarding smaller companies and emerging market stocks. It can be superficial, e.g. using scores based on tallies of negative news articles. It also relies excessively on self-disclosure which carries an obvious conflict of interest and favours larger companies able to devote resources to gaining higher ratings.
• Managing sustainability risk well is difficult using a simple set of rules. This means ESG data is more reliable when capturing metrics which are more easily quantifiable, such as carbon emissions.
• ESG data can play a useful role in sustainable investing, but management of non-standard, complex, and sometimes contradictory data is required. In practice, this requires critical analysis and human judgment. Actively managing sustainable funds significantly reduces the risk of constructing portfolios which are misaligned from their investors’ values.

Engagement is good for your investments and the world

While data provides an interesting glance through the rear-view mirror, engagement helps investors see the road ahead. A company’s approach to managing risks with a high degree of uncertainty – such as modern slavery, workplace inclusion, executive remuneration, waste management, and the transition away from carbon – are likely to be poorly represented by a single data score.

Engagement has been shown to be highly effective at driving positive change in companies, benefiting both society and investors. Engagement and proxy voting are central to active management, which can focus limited resources on a smallish number of companies.

Knowing when to wave goodbye

Engagement holds the potential to drive social returns, and eventually financial returns. It also helps integrate the management of ESG risks into the broader investment process.

Sustainability means more than excluding the most egregious sin stocks, engaging with and on occasion voting against, company management. It also requires investment managers to dynamically adjust exposure to a company without regard to its index weight. This is required when companies take positive steps to become more sustainable, boosting long-term risk-adjusted return potential. It also applies when risks are identified that incur social costs, threatening financial returns.

Managers must be empowered to exit a stock whose values no longer align with investors and/or ESG risks are poorly managed. Any divestment should be contingent upon the manager concluding that further engagement is unlikely to improve its sustainability characteristics. In practice, decisions to sell ESG underperformers are difficult to codify and require subtle judgement based upon analysis.

What does this mean for investors?

Sustainability requires critical data analysis, ongoing in-depth company engagement, and human judgement to ensure holdings align with the Fund’s stated values. This gives active managers a compelling advantage when investing sustainably.

Engagement can help companies become better corporate citizens and outperform over the long-term. The best stewards of sustainable funds are active managers who focus on a small group of stocks without being distracted by the whole market.

Investors who wish to invest sustainably should:

• Be clear about their ESG expectations
• Fully understand the strategy and ESG risk controls of investment products they are considering

An active manager engaging deeply with a limited number of companies is more likely to succeed in reflecting investors’ expectations than more data-driven strategies.

1 Responsible Investment Association of Australia, Australian responsible investment assets hit $1.54 trillion as investment managers agitate for ESG action

2 Morningstar, Christopher Franz: Australia’s sustainable funds market is growing at a blistering pace