There’s scant empirical evidence investment funds that take environmental, social and governance factors into account when selecting investments deliver better returns or lower risk for Aussie investors. At the same time, there’s also no evidence an ESG bias damages returns or heightens risk.
Morningstar’s Sustainable Investing Landscape for Australian Fund Investors report for the second quarter of 2021 shows the value of Australian sustainable investments was $33.42 billion on 30 June 2021, a 66 per cent rise from a year earlier.
“Asset managers have seen this trend and launched ESG funds in an attempt to capture some of the action,” the report’s author Tim Murphy, Morningstar’s director of research for Asia Pacific, notes in his commentary. The research analyses Australian-domiciled global equity funds, given global equities is the asset class with the highest number of ESG funds Australian investors can access.
“On average, there wasn’t a statistical difference between funds that consider ESG compared to the broader index. Some did better, some did worse, some had lower risk, some had higher risk. The important takeaway is you can build a portfolio that’s aligned with your values, that takes these issues into account, without sacrificing returns. But it does come down to individual fund selection,” he adds.
Morningstar’s research also shows it might be too early to tell whether funds that invest with ESG in mind deliver better outcomes. None of the 14 ESG global equity funds Australian investors could allocate money to five years ago have delivered higher returns with lower risk than the broad market index. The results are better across a three year period, with seven funds producing higher returns with lower risk than the MSCI Index.
As Murphy’s faint praise suggests, it’s not a bad outcome, but it’s not a compelling investment thesis. “We want to see some balance to the discussion. More people are very pro ESG, and that’s great, and argue a bias this way delivers superior returns. Equally, more traditional investors may believe limiting your universe of investment assets by applying an ESG screen limits your opportunities. Our evidence says neither is true, in such a black and white sense, with most outcomes landing in a more nuanced middle ground.”
Eddie Barrett, director of investment managers Alvia Asset Partners, says investors should be wary of research about ESG published by fund managers, when the research serves their interests.
“There’s no independent arbiter or framework by which to vet ESG research, so reports that profess negative or positive ESG screening are highly subjective. That’s because assigning a business an ESG rating varies markedly across scoring systems.”
Barrett argues omitting potential investments, or limiting the universe of investments by screening out ‘bad’ companies for ESG purposes, to focus on ‘good’ companies, is unlikely to improve the investment process.
“This is particularly true when the main objective of investment firms that tout a strong ESG focus is to use it as a lever to raise capital. ESG should be one consideration in a comprehensive investment decision-making process, particularly when good ESG practices should already be embedded in a prudent company’s processes as a way of managing long-tail risks.”
Fidelity International portfolio manager Kate Howitt has fascinating insights into ESG and whether a focus on it improves either company or investment performance. “You can come up with all kinds of stories as to why stocks go up and down. But ultimately, it’s about whether there are more buyers than sellers or more sellers than buyers. There are more buyers for better actors than for bad actors.”
Howitt uses as an example the historic demand for energy stocks that normally happens when markets are focused on inflation, which they have been over the past year. “Energy is the sector that has strongly outperformed during previous periods of inflation. To some extent that’s been happening in other markets. But it’s not happening in our market and the only reason you can point to is there’s just not the investor appetite to back hydrocarbons in the way there was in previous inflationary cycles.”
Hydrocarbons are the major component of energy sources such as crude oil and diesel, which are often deemed as having harmful environmental impacts versus renewable energy sources such as solar energy.
“We’re starting to see investors say maybe the future’s not going to be like the past. So, we want our portfolios to deliver a low carbon world. We’re happy to invest in hydrocarbon companies if they’re also charting a course to become hydrogen suppliers of the future. But if they’re not making an appropriate commitment and investment to change their business, then we won’t back them,” she says.
Oil and gas business Santos demonstrates her point. “The stock market is penalising companies like this for their core polluting business and the market doesn’t recognise the value of any emerging green business they are developing. These entities are only recognised by the market once they are spun out of the main business.”
Howitt notes some green tech businesses are trading on extraordinary valuations as investors pile into them. But these are the exception to the rule.
“Look at Fortescue Future Industries. It’s incredibly well capitalised and, if it was carved out of the main Fortescue business, it would be one of the largest pure play green businesses in Australia. But because it’s tucked inside Fortescue, and because Fortescue sells lower grade iron ore that is going to be progressively more disadvantaged as we moved to a decarbonised world, the market is not recognising FFI’s value right now.”
Barrett says it’s difficult to gauge whether companies with strong ESG policies perform better than companies without the same focus on how these elements shape their operations.
“Without a centralised body dictating what qualifies as pro-ESG, the market is being dictated to by the whimsy of well-fed PR machines, determined to greenwash some market players at the expense of others.”
Barrett stresses having strong ESG policies and actually implementing them are vastly different things. “Companies with extensive ESG policies outlined their annual report don’t always do a good job manages ESG considerations across their operations. Equally, company that does not publish may have always considered ESG as part of standard corporate policies and procedures.”
These are complex themes for investors to digest as they decide where to allocate their funds. https://www.afr.com/companies/financial-services/market-awash-with-products-to-meet-demand-20211114-p598rz