Jul 12, 2021
Welcome to Finance and Fury - Is ESG investing the way of the
future and good for your portfolio?
Within the last few years, large publicly listed companies and
investment managers investment are really paying attention to what
is known as an ESG score – which stands for environmental, social
and governance – it is meant to be used as a determinant on the
sustainability of investments – the concept of sustainability it is
growing in prominence in every sector of the economy, but
particularly within institutional investments and publicly listed
companies
In this episode – I want to look at what is ESG, how it is
determined and scored, and can following this trend and only
investing in ESG companies help your bottom line when it comes to
long term returns?
To take a step back – society has been moving towards greater
levels of sustainability and environmentalism – with this shift –
Publicly listed Companies are becoming concerned with where they
fit into this – as well as investment managers wishing to purchase
these companies
- if you are a fund manager investing in a weapons manufacturing
company, is this an ethical investment based around ESG metrics? If
it doesn’t score well and your mandate determines that you cannot
invest in low scoring companies then this would have to be excluded
from your portfolio – even if the world is going to war and
Raytheon is about to make a lot of money
- But from Raytheon’s point of view – you want to be considered
by professional investment managers to be an ESG company so that
that institutional money can flow your way – because if you are cut
off from that market, your share prices will suffer and you would
be failing your duty as a board member to maximise shareholder
value – i.e. providing returns to shareholders
- So major corporations are becoming very engaged with the
parties that provide ESG scores to help not only incentives further
investment in their business – but also to help determine from an
outside/institutional perspective if the company is worth investing
in – as public investors have shown an interest in putting their
money where their values are –
- This has also seen the rise of many managed funds, brokerage
firms, and ETF providers offering products that employ ESG criteria
as the sole determinant for investment decision making – people
want these products so the market is providing to meet this demand
– but does following ESG scores as a criteria for an investment
strategy actually work for a long term investment strategy?
What is ESG - Environmental, social, and governance criteria are
a set of standards for a company’s operations
- Environmental criteria consider how a company performs as a
steward of nature - can include a company’s energy use, waste and
pollution, natural resource conservation, or treatment of animals
- criteria can also be used in evaluating any environmental risks
a company might face and how the company is managing those risks -
For example, there may be issues related to a company’s ownership
of contaminated land, or its disposal of hazardous waste and
management of toxic emissions, or its compliance with government
environmental regulations
- Social criteria examines how it manages relationships with
employees, suppliers, customers and communities
- Does it work with suppliers that hold the same values as it
claims to hold? Does the company donate a percentage of its profits
to the local community or encourage employees to perform volunteer
work there? Do the company’s working conditions show high regard
for its employees’ health and safety? Are other stakeholders’
interests taken into account?
- Governance deals with a company’s leadership, executive
pay, audits, internal controls, and shareholder
rights.
- A big one I have seen is ethics of the company, board
composition and transparency – does the company uses accurate and
transparent accounting methods and that stockholders are given an
opportunity to vote on important issues? Do they have a diverse
board, or is it all old white males? Are there any conflicts
of interest in their choice of board members, do they use
political contributions to obtain unduly favourable treatment, or
do they engage in illegal practices?
- ESG investing is sometimes referred to
as sustainable investing, responsible investing, impact
investing, or socially responsible investing – however –
this is very similar to CSR - Corporate social responsibility
Based around these criteria - an ESG score is calculated
–
- An organisation’s ESG score is a numerical measure of how it is
perceived to be performing on each of these criteria – Each of the
Environmental, social, and governance criteria are given an
individual score then it is combined into one
- The key word in this score is ‘perceived’ - An ESG score is
calculated based on how an organisation is seen to be performing –
that is, how its behaviour relating to ESG issues is reported – not
what it is actually doing behind closed doors
- Just as with the building of corporate reputation, there
is a gap between reality and perception. While a business may have
a strong policy around carbon emissions and waste reduction, or a
system of transparent, performance-based promotion, if that
information is not in the public domain, it won’t impact its ESG
score.
- Alternatively – if a business has a face value of supporting
every social movement whilst enacting policy behind the scenes that
is antithetical to these values, then this is not picked up in
these scores - ESG scores don’t necessarily reflect the internal
reality of a company - as ESG scores only measure how corporate
behaviours are reported and the face that they put on to the
public
- Therefore, a reality gap exists – and poses a risk – as if you
are basing investment decisions purely around an ESG score, then
this not meet your investment desires if you are trying to invest
in a socially responsible way
- Let’s have a look at a few examples – when comparing the ESG
risk scores
- Disney – they have a wonderful public perception – and own a
massive chunk of media and merchandising rights – theme parks,
movies with the rights to Marvel, Star Wars, media as well, like
ABC in the US – they also have merchandising rights, so many toys
are marketed and made – where are they made? Well, it has become
apparent that it may be slave labour – through internment camps in
China –
- So – based around the issues with the use of Chinese free
labour – how would they rank? Pretty poor you would think - ESG
Risk rating is Low based around the official metrics – 14.9 –
Actually a lower risk than Netflix – they are given a ranking of
87% by CSRHUB – which is an ESG rating agency
- Another example – Tesla – Most people would consider this
company as very environmentally friendly – good social governance –
and is great for society at large – on a score of 0-50 – where 0 is
no ESG risks, meaning it is the cleanest company on earth with the
best contribution to society and lots of diversity in the board and
management – where would you place Tesla – 10? 20? – well it is
31.3 – which is high risk – CSRHUB gives them 38% out of 100%
- But good news – BWM, or Daimler are all lower – 27.7 and 25.2 -
CSRHUB gives Daimler 87%
- To put this in perspective – BHP has an ESG risk rating of 30.1
– with a 75% rating - so Tesla is a lot lower – even BP Oil got
64%
- How are these risk scores calculated? Because does it make
sense that these companies rank where they do?
- It comes down to who is doing the scoring - Analysis companies
use various calculation processes – but these scores are done at
the behest of these companies – If you are a major company, you go
to a rating provider, hand over all your information and they come
up with a score – some of those scores I mentioned come from
Sustainalytics – a subsidiary of Morningstar – one of the worlds
top rating agencies - the others come from CSRHUB
- Due to the individual companies’ methodologies – it is actually
harder to determine what contributes to an individual score – as
these will vary depending on which analytics they employ. Research
by State Street showed only a 0.53 correlation between
ESG scores for the same subjects between another provider, MSCI’s
ESG ratings and Subanalytics – therefore there is about a 50%
relation between a score on their board, or their environmentalism
– so one company that may seem to be an ESG champion on one site,
may not be on another
- This is all due to the fact that ESG scoring is the measurement
of perception rather than reality - so ESG data systems can be
largely subjective and vary dependent on which company is doing the
rating
- so how does anyone make an accurate investment decision based
around these wildly varying metrics?
- The answer is that you really can’t under their current form
ESG ratings and scores are often based on voluntary company
self-disclosure and partial data.
- The issue is that most ESG scoring systems from some companies
include an analysis from publicly available print and social media
content – so if a companies social media profile supports social
movements domestically, whilst using slave labour abroad which is
not incorporated into the metrics – this company will appear to be
a higher rating on ESG than a company that doesn’t participate in
the same practices, but isn’t as active in changing their twitter
profile
How does an ESG investing approach help with portfolio returns
–
Looking at a few examples –
- Australian iShares ESG fund – Holdings, CBA, CSL, WES, MQG –
but then FMG, Transurban, Newcrest, James Hardie – and Xero – so in
the top 10, three are mining companies – performance wise this was
only created this month – so no data
- Other Funds – BetaShares has an Australian Sustainability
Leaders ETF – 1 year is 17.79%, 3 years is 10.80%
- The benchmark index of the Nasdaq Future Australian
Sustainability Leaders Index – which the BetaShares fund has
underperformed by 0.5% at every stage
- Another Australian Fund is Van Eck - 1 year is 25.02%, 3 years
is 10.17% or 5 years of 7.59%
- In comparison – the ASX300 provided 28% over 1 year, 9.74% over
3 years and 11.2% over 5 years
- iShares Core MSCI World ex Australia ESG Leaders ETF – Returns
of 30% over 1 year, 14% over 3 years and 14.5% over 5 years
- International index - 28% over 1 year, 14.8% over 3 years and
15% over 5 years
- There is no clear winner – The indexes have slightly
outperformed in the long term
Can this be a good investment for the long term – as more people
start ESG investing?
- There could always be the issues of "Bad" companies performing
very well and missing out on this –
- However – due to public perception – A company with a higher
ESG score may start to gain more traction in regards to
investment inflows – especially from financial services companies
such as JPMorgan Chase, Wells Fargo, and Goldman Sachs – and ETF
providers in Australia
- The very nature of more money flowing into highly rated ESG
companies could be a long-term investment – not for the actual
performance of the companies themselves in fundamental terms – but
from a perspective of more money flowing into these companies and
hence the prices go up
- Even for one of the largest investment sectors within Australia
- Superannuation funds – Their mandates may limit or eliminate
non-socially responsible investing
- We have seen the divestment from Coal within superannuation
funds over the past 12 months – coal companies on the ASX are not
faring well – most have seen a decline in prices over the past few
years – many saw a loss in EPS recently with coal prices plummeting
to $50USD a tonne in July 2020 – but it is back to all time highs
at $136USD a tonne – so coal companies may actually rebound quite a
bit – but this component of return may not be included in the ESG
investing
- Brings up interesting issues – as a super fund their fiduciary
duty is to provide long term returns for the sole purpose of their
members retirement - choosing investment strategies based entirely
on investments classified under ESG and socially responsible
investing score could start to lag markets depending on the score
allocated to companies
- Remember – score can be subjective – large companies with a
good social presence and the ability to have great PR
In summary –
If you are going to be investing only in Large cap companies and
using ESG metrics – probably nothing to be gained here – they will
all have great ESG scoring based around the metrics and how
companies determine these scores –
Mid and Small cap companies – these may be left unloved by these
types of funds – but this is where a large chunk of capital growth
comes from the market –
Companies at the top that have a large portion of the market
shares have limited capital growth when compared to new companies
coming in
If you are going to invest – then invest – if you are looking
for ESG – don’t rely on metrics from companies providing these –
decide if a company meets your ethical criteria
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