NZ’s staggering RI growth

The Responsible Investment Association of Australia recently released its Responsible Investment Benchmarking report for the 2016 year. For those interested in responsible investing, it showed some quite remarkable growth in funds in New Zealand managed using responsible investing guidelines. With year-on-year growth of over 2500% (from NZ$1.6 billion to NZ$42.7 billion), at face value the report indicates quite a remarkable transformation in the NZ managed funds scene. 

Yet the picture isn’t quite as dramatic as it first appears. In August of last year, the New Zealand Herald published a story pointing out many Kiwisaver funds owned shares in companies that are banned by various United Nations Conventions (land mines, cluster munitions, nuclear weapons). In response to this story, most affected Kiwisaver funds took an initial step into the Responsible Investing world by implementing an exclusions based policy, removing where possible the few companies affected by the UN conventions. 

Some providers moved much faster than others – in fact some are only implementing changes now. This illustrates for some how difficult it will be going forward to have a dynamic RI policy when they outsource the stock selection.

But are exclusions enough?

Globally, responsible investing has moved far along from a purely exclusions-based policy. In fact, many argue that managers following an exclusions policy only are merely paying lip service to the ideals of responsible investment. It is a reactionary approach and indicates a lack of belief in the idea that well governed, socially and environmentally responsible companies will tend to be better than their less enlightened peers. It also indicates a negative world view by exclusions only investors – are they excluding companies because it is a well thought-out policy or just because regulators and clients are forcing them?

In broad terms there are four approaches to responsible investing: Negative screening or exclusions, thematic investing, impact investing and full Environmental, Social and Governance (ESG) integration. As well as these, there is the concept of engagement – voting at AGMs and applying positive pressure for companies to improve their ESG policies. Different managers can use some or all of these in different ways. At Pathfinder, we certainly start with this exclusionary approach, but go further to fully integrate ESG factors.

Exclusion-based investing, though a start, is actually a negative way of looking at responsible investments. Managers take out companies from certain industries – i.e., Tobacco, Controversial Weapons, Gambling, Adult Entertainment and Thermal Coal production/usage (sorry President Trump!). In terms of responsible investing, exclusions is taking a step, but the bare minimum step.

As its name implies, thematic investing is an approach where the investments chosen in a portfolio are consistent with a particular narrative. Examples include low carbon emissions, social justice, solar energy and, in the case of Pathfinder, our Global Water Fund that invests only in companies that have significant revenue from activities that support the treatment and distribution of fresh and waste water.

Impact investing is harder for managers investing in listed companies as these are normally private (unlisted) investments. The idea is that capital owners will invest where their investment can generate measurable and beneficial social or environmental impact. This may or may not be at a monetary cost. Well-known impact investing include micro-finance initiatives in less developed countries, investment in infrastructure to provide safe water and community-based health projects. The capital owners may be content with a lower financial return if they value social benefits more highly.

Full ESG integration is where the responsible investment industry overseas is fast migrating to. It is much less a leap of faith now than it was several years ago. Previously, when asked, most investors would state that ESG investing implies a lower return than non- ESG investing. Now, that conversation is changing, as investors now agree that funds following an integrated ESG approach will do no worse than average, and may in fact do better. Data from the RIAA shows returns for three sectors (Australian share funds, International share funds and Multi-sector growth funds) across timeframes of up to 10 years. RI is behind over one year but over three, five and ten years, RI funds did the same or better over seven out of nine periods.

How is ESG incorporated?

ESG integration is here and will only become more important as investors demand it, and track records are generated. In practical terms though, how do managers implement it? Some just do their normal stock analysis and then check each stock for “appropriate” levels of ESG-ness before buying it. A safe approach but, again, these managers aren’t fully invested in the benefits of ESG as an investible factor.

At Pathfinder we take a much more direct route. We believe (and there is ample evidence) that the ESG characteristics of a stock have a direct impact on the relative return for that stock. More simply, in the long run, we believe that stocks with high ESG scores will outperform peers who do not have high ESG scores. Logically this makes sense – high governance scores should imply that a company makes better, more robust decisions. High environmental scores mean fewer incidents that could result in legal actions or clean up costs. And high social scores should mean better engagement with customers, a happier and more productive workforce. None of that is difficult to appreciate. In our responsibly invested equity funds we actually treat ESG scores as a market factor, in the same way as we look at geography, sector, value factor, growth factor, dividend yield factor etc. When we build a diversified portfolio from our exclusions-screened universe, we value more highly companies with high ESG scores than their peers and, essentially maximise the overall portfolio ESG score, subject to constraints and minimums/maximums around other market factors.

Increasingly, the investors we speak to are demanding a more integrated approach to ESG, and seeking out portfolios that match their own core beliefs, but comfortable in the knowledge there is not necessarily a performance gap for being responsible.

Paul Brownsey

Pathfinder is manager of its Global Water Fund and Responsible Investment Fund.This commentary is not personalised investment advice - seek investment advice from an Authorised Financial Adviser before making investment decisions.