The last 12 months will be remembered as the year when environmental, social and governance (ESG) investing hit the mainstream. It has at least partially restrained the momentum behind passive investing, creating more opportunities for active fund houses to prove their value.
But despite the boom driving global ESG assets to a total $30tn (£26tn) globally, sustainability, criteria standards and terminology remain opaque and fragmented, leaving open questions as to whether its current level of adoption is building a solid, structural base for expansion. Wealth managers have nonetheless rushed into the sector, suggesting short-term momentum will be maintained into 2020.
While fund houses concentrate on making sure they are able to reap the benefits of demand for ESG, wealth managers explained to us how they are managing and responding to the growth in client demand and provided some insight into the future of the sector, and what it means for active management.
MORE MONEY THAN EVER
The momentum behind ESG has been snowballing, with UK-based sustainable funds spiking from £4.4bn in 2008 to £15.4bn in 2017, according to the Investment Association.
There is ‘more money than ever’ going into ESG funds, said Hortense Bioy, director of sustainability research at Morningstar. This is underpinned by broader risk appetite in addition to a focus on climate issues, ‘the number one concern for investors today’, she said.
In fixed income, where the variety of bonds related to ESG is growing, green bonds have surpassed $1tn assets globally, with eight green bond funds launched last year, she added.
John David, head of Rathbone Greenbank Investments ― which surpassed £1bn in client assets in 2017 ― said while ethical investors still did not have the full toolset available to wealth managers, it is increasingly easy to assemble a sophisticated multi-asset fund.
‘It is certainly true to say that there are limited ESG options in assets such as hedge funds and structured products, but this is changing,’ he said.
Camilla Ritchie, investment manager at 7IM, said there are still significant blindspots to be aware of, however.
‘I have found social impact Reits to replace traditional Reits and renewable energy infrastructure to replace traditional social infrastructure, but there are still a number of sectors which are difficult to replicate – commodities are difficult – especially gold, which is usually mined in a non-ESG way’, she said.
Can ESG investing continue to grow?
Valentina Romeo
vromeo@citywire.co.uk
Environmental, social and governance investing was the key theme of 2019, but can the sector maintain its allure as longer-term track records kick in?
ESG FOMO
Despite these remaining limitations, the ways in which wealth managers use sustainable funds is now almost as broad as traditional unencumbered mandates, through in-house portfolios, mandates or direct exposure to stocks or external funds.
‘There’s been a big change over the last year, some of the people not allocating at all [to ESG] feel they now have to’, said John Fleetwood, director of financial advisers 3D Investing. But ‘for a lot of [wealth managers] they still see ESG in simple terms and some of them adopt a traditional ethical approach’.
Whatever the approach to ESG, experts recognise that it is becoming an industry standard and an integral part of the investment process. ‘This is a structural trend highly unlikely to be reversed’, said Patrick Thomas, head of ESG investments at Canaccord Genuity Wealth Management, which claims to be one of the first top wealth firms to launch an ESG-dedicated portfolio service.
‘Your average private client portfolios are going to be heavily underweight companies such as clean energy and cybersecurity because they are newer. An upside risk you might have might be that the world transforms and these themes become very important investment drivers and your portfolio is underweight them,’ he said.
‘It will be similar to five years ago when you were thinking social media was not important or fast fashion wasn’t decimating the high street.’
NEW THEMES
In a 60% equity allocation in a balanced portfolio, Thomas has around half in ‘traditional ESG integration’, and the other half in themes, such as battery technology, with the L&G Battery Value Chain ETF, and high-tech composites, via the RobecoSAM Smart Materials fund.
A similar approach has been adopted by the long-running 7IM Sustainable Balance fund, managed by Ritchie since its launch more than a decade ago.
She said the fund began life with a relatively narrow ‘ethical’ approach, but has since adopted a more thematic style ‘because that’s why people think this is the way to run a sustainable fund’, she said.
‘The sustainability spectrum goes through ESG, thematic and now impact investing, looking at the output of companies, not just the ESG input’, Ritchie said.
Ritchie’s fund manages its asset allocation and fund purchases in-house, but contracts direct equity and direct bond portfolios to Sarasin & Partners. The portfolio is mostly made of direct equities alongside funds such as the Threadneedle Social Bond, NextEnergy Solar Income funds and ESG-compliant passives.
The £105m fund has outperformed 7IM’s own Balanced fund almost every year over the past 10 years. Over the last year the fund has returned 8.8% against the 5.7% of the 7IM Balance fund and 7.7% of the IA Mixed Investment 20-60% index.
RESEARCH EFFORTS
Charles Stanley launched two ethical model portfolios in 2018 in its first specialist offering. ‘The asset allocation for the portfolio is driven by what the end client wants,’ said Rob Morgan, analyst at the wealth manager.
But he points out that the lack of data when it comes to ESG continues to prove challenging for fund selectors and their due diligence. Reflecting the challenges of identifying ‘apples-to-apples’ comparisons, active fund selection can both add value and offer reassurance, he said.
‘We are a little bit sceptical of the rating agencies. There are huge gaps in terms of data ― on bonds or smaller companies where we have a strong conviction, they don’t come up in ratings, so some scores come up as just “average”,’ explained Morgan.
Despite the data issue, he said fund managers still need to make the effort to create better reports and give investors something tangible, ‘to show that this is not just another fund’.
He added: ‘We like to see the process completely embedded in their strategy, not just an additional screen and with the ESG analyst really part of the team. It is not necessarily about longevity [of the fund]. They need to have history within the industry and that gives them credibility.’
Another outstanding issue is the question of fund managers’ incentives for marketing sustainable strategies and whether ESG considerations are actually a material part of the investment process.
Shore Capital analyst Paul McGinnis said there can be a disconnect between fund managers’ financial analysis and the ESG engagement with companies.
‘You have the fund managers engaging on the financial strategy and then you have the ESG team talking with the counterpart ESG level of the company, therefore the extent to which all that is joined up I suspect is very variable,’ he said.
ESG IN 2020
Unsurprisingly, ESG is expected to become even bigger in 2020, with a deeper focus on engagement, outcomes and how to measure them.
The regulatory agenda is also going to provide impetus to a push on sustainability within the advice process. Mifid II amendments will make it mandatory for investment managers to integrate ESG considerations into their processes, make their policies public, and report on risks and impacts of funds and discretionary services which are marketed as sustainable.
‘ESG as a general risk management tool will become the majority,’ added Fleetwood. ‘And on the other end you have the emergent impact funds, which invest positively rather than negatively’.
Morgan also believes that the focus will grow on the non-financial benefits of ESG and move the debate on whether passive funds are a viable option for ESG.
‘With ESG you’ve got to be so careful because of the index you are following, that’s why you tend to end up with controversies. An active fund manager can add alpha and add so much research on ESG, so they are going to be moving up the rating. That’s how they can add some value.’
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