Future Focus: Don’t believe in ESG? There are reasons why you should.
Are you willing to put your money where your mouth is?
I’ve been getting served a lot of ads for ethical superannuation funds. They don’t invest in companies involved in mining or exploration, nothing to do with armament or weapons, or businesses engaged in unethical human treatment.
They don’t just avoid certain companies. They also proactively invest in the improvement of our collective future – climate, social inclusion projects, etc. It’s about creating an equitable world as well as financial outcomes.
If my money is going to be invested anyway, why shouldn’t it be invested in a way that makes me feel good?
It seems this is the train of thought for many Australians. Investors are pulling money out of sustainable funds globally. We’re bucking the trend in Australia - money keeps flowing in.
Sustainable fund flows: Australia bucks the trend
Environmental, Social and Governance (ESG) has always been a polarising and contentious topic with investors.
Traditionally, ESG has been thought of as an exclusion list, and associated with ‘feel good’ investing. Certain companies are removed from the investing universe if they don’t meet the standards of investors. Say goodbye to sin stocks like tobacco companies and alcohol companies. No more coal companies and weapons manufacturers.
Some investors remain uneasy with ESG with the impression it is a trade-off between picking the investments that will provide the best return and those that live up to certain moral standards. Adding to this, there is opacity around what ‘ESG’ actually is – the definition and criteria for inclusion or exclusion varies from fund manager to fund manager.
This can be tough to reconcile with a valuation based and financially minded view of investing. One of the issues with ESG is that investors conflate ESG and impact investing. They are very different.
ESG risks are real and investing is about evaluating risk
Sophisticated investors increasingly view sustainability as a way to understand the vulnerability of their investment portfolios to ESG factors. It is no longer about doing good but instead taking a more holistic investment approach. This is an important distinction – because risk and return are intertwined.
As an investor I want to be compensated for taking on risks. It is taking on risk that enables me to earn returns. However, in order to actually do this, I need to look at the full spectrum of risks and how they impact the long-term cash flows generated by a company. Without a full view of the risks associated with a company I can’t judge if the valuation is attractive and compensates me for the risks.
A company like Coca-Cola KO is a great example. It’s a strong business that is sold in over 200 countries, with more than 1.8 billion beverages consumed a day. Our analysts assign Coca-Cola a wide economic moat, meaning that they believe that the business will maintain a sustainable competitive advantage for at least the next twenty years.
Coca-Cola is able to do this through it’s strong brand underpinning price power and close retailer relations. It’s also got scale benefits because it has a massive global distribution system. They’re able to reinforce their competitive position and drive excessive investment returns for at least the next 2 decades.
This is by all accounts a solid business. However, to make that statement definitively all the risks must be considered along with the way the company is trying to mitigate those risks.
For example, we can consider the main ingredient in all of Coca-Cola’s products – water. How is an investor to know if Coca-Cola is a good investment if they do not look at increased levels of drought when water is one of the key ingredients in most of their products?
Beyond drought conditions there are several other risks to consider. There is the obesity epidemic and potential sugary beverage taxes. There are container deposit schemes due to environmental concerns related to waste.
These are all issues that are correlated to ESG investing but have real implications to the risk and future value of the company.
One of the reasons that I find our analyst reports valuable is because risks are intrinsic to our company level valuations at Morningstar. That gives me a full picture of a company. Our analysts evaluate which environmental, social, and governance issues are financially material. Then they consider what is being done to tackle these material risks and how the risks affect companies’ long-term value.
ESG investing is less about trade-offs between doing good and earning strong returns and more about not putting our heads in the sand as investors when we evaluate companies. It is understanding that these ESG issues are not for investors to sleep better at night, but for all investors to understand the prospects of the company they are invested in.
Ultimately, high ESG risk companies can be equally as attractive as low risk ESG companies. Investors have to think about the price that they are paying for the value they are receiving. It is all about being compensated for the risk that they are taking on. Markets can and will be overly focused on near-term issues. If the share price moves due to an event and it is an overreaction, that may be an opportunity for investors.
We can see this closer to home with AMP AMP. AMP has faced long term impacts to their brand after the Royal Commission, as well as their handling of sexual harassment claims.
AMP Ltd.’s share price to Morningstar analyst fair value
The chart above shows the impacts of the Royal Commission to the long-term intrinsic value of AMP. The cuts to fair value that happened in 2021 were related to the sexual harassment claims from Boe Pahari.
These issues should not be compartmentalised as ESG issues that cause divestment from investors so they can sleep better at night. These issues have been detrimental to the long-term value of the company and should be important to you as an investor or shareholder regardless of your stance on ESG.
We can also see at multiple times during these incidents, the sell offs pushed the prices into undervalued territory. These are the times where high ESG risk companies can still make attractive investments at the right price.
What am I giving up?
ESG funds are still experiencing positive flows in Australia. The question is if ESG investors are giving anything up.
ESG funds have a reputation for being expensive and underperforming – usually the two factors are correlated.
Finder ran a survey that looked at how much investors were willing to give up to put their money with their mouth is. 44% of Australians are willing to earn less of a return on their investment in exchange for having a positive social impact.
How much were they willing to give up? On average, 2.62% p.a. However, 13% of respondents were prepared to sacrifice more than 4% p.a.
Let’s look at an example of what this actually looks like. Take a 30-year-old with $100,000 in their superannuation account with a plan to retire at 65 years old. This individual earns $100,000 and do not experience wage growth over this time while investing 12% annually ($10,200 post-tax) into their superannuation. They achieve 8% returns p.a. (6.8% post-tax).
The majority of surveyed investors were in Gen Y and Gen Z – those with the longest time horizons until retirement. As the previous example shows, younger investors are those with the most to lose as they have the most time for fees or poor performance to compound.
The larger question is if the trade-off that the finder survey uncovered just a myth. Do you give up returns if you purchase ESG investments? And does ESG improve the world?
Myth 1: ESG means lower returns
It is hard to say. The issue with ESG funds is that they do not have a regulated standard for what they invest in and what they avoid. Some funds have more screens than others. Others just declare that they ‘responsibly invest’. These are all technically included in the data set.
If we look at the performance of Certified responsible investment products performance is impressive. Over the past 10 years, they have delivered an average return of 13.2% p.a. This is well above the average return of other Australian share funds, at 9.19% p.a. Investors are not giving up any returns there.
I ran some similar performance tests with Morningstar data. Those Australian funds that were ESG intentional investments achieved a 5-year annualised performance of 11.14%, with an average Total Cost Ratio of 1.17%. Those that had no designation and that were not intentionally screening achieved 11.05% over the same period, with an average Total Cost Ratio, or fee, of 1.26%. Fees are included in the performance data.
Myth 2: ESG improves the world
The underpinning of ESG are divestment campaigns. One famous example is the divestment campaign against Apartheid South Africa. Global pressure led many companies to pull out of South Africa, applying economic strain that contributed to political change. It’s often cited as proof that ethical investing can have a real-world impact.
Yet there are some fundamental differences to divestment from a country that made up a relatively small impact on the finances of global companies and not investing in a coal company. The coal company is a coal company. It can’t be anything else. Especially if sources of financing dry up.
This brings us to impact investing. Impact investing is deliberately funding companies that are solving problems that investors think are important. That is very different from avoiding companies with products and services you disagree with.
Finally, there are many people that believe the secret to improving the world is not to avoid certain companies. It is to invest in them and enact change from within – whether that be pushing for emission targets, better governance and human resource practices.
What should investors do?
There’s a tension and often two-sided degradation of ESG and non-ESG investors. We see those that do not believe in ESG investing often label those that do as ‘woke’ or believe their investments to be inferior. On the flip side, we see some ESG investors believe they have some sort of moral high ground.
There’s not many instances in where I’d quote Bob Katter, but this is a situation where I think it is appropriate. ‘Everyone is entitled to their…proclivities, let there be a thousand blossoms bloom as far as I’m concerned’. Every article I write, every podcast we put out, every video we record – we talk about the way to be a successful investor. Being a successful investor means investing in a way that suits you and your circumstances. If investing in a mining company now does not sit right with you today, it’s unlikely that it’s going to sit right with you in a month. Invest in companies that you’re likely to stay invested in.
I believe that all investors must consider the risks in their portfolios, and ESG considerations are part of that risk spectrum.
If impact investing is important to you, ensure that you are not sacrificing half your retirement for it. Morningstar research has found that you’re able to, with relative success, protect your returns by investing in low-cost funds. In fact, our research has found that a fund’s annual fee is the most proven predictor of future fund returns.
If you are choosing an ethical fund, choose one that does not charge you too much for the privilege of investing.
If you invest in direct equities, understand the limitations of the universe you are investing in and the opportunity cost of forgoing investments that may help you reach your financial goals.
If you are an investor who does not believe in ESG that is fine as well. Just understand that impact and ESG are two very different concepts. We mentioned before that investors exchange risk for return. ESG are risks that impact the companies that you invest in. Like AMP, these risks can be detrimental to the intrinsic value of a company over the long term.
