More than Money?

What is more than money? BlackRock CEO Larry Fink in a 2018 letter to portfolio CEO’s informed them that the new direction businesses ought to take is one where they pursue more than profits if they wanted to be perceived as a good investment by BlackRock.

By Tousif Shaian Hafiz

Externalities are not a new concept in the world of finance and factoring them in to the pricing of assets and investments is not alien, in fact, carbon pricing has been the basis of some assets that have been available on the market for a couple of decades. ESG products on the other hand revolve around more than just pollution-pricing and aim to encompass a broader set of social impact metrics, hence the acronym standing for ‘environment, social, and governance.’ Investors in the ESG-universe are often looking to make targeted impacts with their investment dollars by assessing and pricing how companies can make a difference in concerned areas, such as gender equality, environmental governance, social welfare impact, and more.

A general rule of thumb when investing in to the ESG world is that the yields will be lower than compared to non-ESG investments in similar sectors and factor exposure (small cap, growth, etc). The intuition behind this truism is that if investments carry a consumptive good benefit for the investors (be it a social or personal benefit) than that investment comes with a premium price point compared to a similarly performing asset that does not carry that same benefit. Think of it in terms of purchasing a name brand white t-shirt versus an off brand from the same factory or buying a Porsche versus a Toyota for your daily driver.

In investing scenarios, it also helps to consider it in this way: if one were to invest heavily in arms companies rather than pharmaceuticals, there is a social cost that may be incurred from friends, family, or other in the same network (reputational and social), or from yourself if you do feel morally opposed to the investment (psychological). The logical mind would say that they are good investments in financial terms, but people are rarely that simple. What this means is that if some, but not all, of the market is willing to pay a premium for ESG-standards than the price of these assets will be higher than non-ESG products, even with lower returns.

Historically this has held true, however as ESG investments have become more popular and documentation has shown that ESG-driven companies tend to perform better over time, this truism has had to be reconsidered. Currently, there is still a relatively mixed indicator of how ESG-assets perform in the market, and ESG-funds still do perform worse than similar funds within a given sector. However, this is not a universal trend, as for example ESG-assets that are weighted towards governance standards tend to perform better than the market, whereas social weighting tends to underperform. It is also important to consider that ESG-assets tend to be less risky than non-ESG assets within similar sectors.

So then, why is there so much buzz about ESG-assets?

The first one is regulatory tightening that tend to affect companies ahead of the ESG-curve less than their competitors. Regulators and investors are increasingly demanding greater transparency from companies, be they ESG-led or not. This plays hand in hand with the earlier point about the risk profile of these assets. The other point is that the general intuition behind ESG-standards is relatively poignant in design. Consider this intuition: stronger governance standards, if actively managed, means that a company is cracking down on institutional fractures more readily which, over time, mean that the company is operating more effectively than a competitor with less tight governance standards. ESG encompasses such a broad area of corporate design that ensuring high standards in the area is an indicator of good housekeeping and signals to investors and regulators that a company is functioning well. Good performance in ESG communicates a firm’s ability to be more sustainable, environmentally friendly, and operate in a manner conducive to staff retention and performance which is why these companies tend to weather economic storms better than their counterparts.

So how come investors have not gone full dive into ESG?

The first point is that there is still mixed-research on how ESG-assets perform compared to their peers, but that historically, there has been a level of return differential in favour of non-ESG assets as investments. Broad market analysis indicates that the fees of ESG funds tend to be higher than in other diversified market-weighted index funds, thematically focused, and other targeted factor funds. The turnover is higher as well due to higher levels of scrutiny in the assets within the holdings, and an any form of subsector targeted portfolio will never be as diverse as a non-targeted portfolio can be simply by design.

So how does an investor navigate around these pitfalls?

The first thing is to understand how higher ESG-scores are beneficial to a company. The big one to bear in mind is that higher ESG-scores tend to be associated with a lower cost of capital. This is due to ESG-companies being lower risk relative to their peers. They are usually better run companies, more stable, and have tighter financial controls than their peers. This makes these companies better overall investments in the long run.

The next thing to consider is that ESG-analysis can be a powerful tool when done right. ESG is the opposite of a free lunch – it is expensive and can cause significant setbacks to investors if they are not scrutinous in how they approach investing in these assets. The top ESG funds are those that can truly deep dive into company data and understand the way ESG standards affect the firm on a granular level. Is a firms supply chain monitored regularly to meet anti-slavery standards? How regularly does a firm update code of ethics and ensure staff compliance? Are the business development processes employed by this firm making sure to meet ethics standards? To keep track of all these categories as an investor, to truly ensure that your investments are in-line with your expectations regarding ethical investment, is expensive and very time consuming, so it is often simpler to invest in ESG-funds.

FUNDSaiQ is a powerful way to go about identifying the right ESG-funds for that purpose. As mentioned earlier, ESG-funds tend to have higher overall fees compared to similarly performing non-ESG funds, and part of that is due to the high costs associated with ensuring that portfolio companies are meeting their ESG-related requirements. What FUNDSaiQ allows for is to find the firms that do overperform their comparable peers net-of-fees so that investors can have their cake and eat it too. For advisors, FUNDSaiQ can identify the top 2% of actively managed ESG-funds across multiple thematic preferences so that their clients do not have to choose between performance and sustainability. And that is a powerful thing to be able to do as the more investors push for higher ESG-standards, the more companies are compelled to engage in sustainable and ethical behaviour. And for advisors, the ability to provide for their clients the best performing options for areas of ESG-assets and issues that they care about is giving them far greater value than they would get than if they were to simply invest in a standard weighted ESG-fund.