Responsible equity investing – does it pay to play nice?

Written By: Paul Myles Director, Institutional Business BMO Global Asset Management

Paul Myles of BMO Global Asset Management examines the effect that the integration of ESG considerations can have on equity strategies

Widespread awareness that investment decisions can and should address ESG factors has led to significant demand for responsible equity products. This article looks at how far the LGPS has come in terms of integrating ESG into its equity investments, as well as look at the debate around the impact on performance.

Statutory guidance issued in 2017 required that local authority funds in England and Wales include in their investment strategy statement an explanation of their policy on environmental, social and governance (ESG) considerations. The advisory board for the UK’s local government pension scheme recommended that the guidance go further, and reflect the government’s policy on climate change and wider responsible investment considerations.

How does a sustainable strategy affect performance?
Equity investing will remain a core component of investment portfolios – but how the industry invests in this asset class is changing. There is growing demand for financial decisions to reflect ESG considerations. Traditionally a trend driven by personal values, there is now increasing momentum from a regulatory perspective. Last year, the EU regulator introduced mandatory disclosure by asset managers and advisers of their sustainability policies¹. The Department for Work and Pensions introduced legislation in September 2018 to change the habits and approach of pension schemes, shifting the onus onto trustees, who must clarify their ESG policies with regards to their approach to financially material and non-financial risks.² Asset managers are implementing investment policies and products that include appropriately disclosed ESG criteria, often linking these to the UN Sustainable Development Goals (SDGs) – 17 global goals designed as a blueprint for a more sustainable world by 2030.

Another driver of increased demand is the growing consideration that aligning investment decisions with ESG issues doesn’t necessarily mean compromising on performance; in fact, it can mean quite the opposite. Don’t just take my word for it – a review of over 200 academic papers found that 88% showed a link from good ESG practices to good business performance³.

Risk management matters
History provides stark examples of what can happen when businesses fail to consider and prioritise ESG issues. Consider the 2010 BP Deepwater Horizon disaster, where cost-cutting and poor safety systems contributed to the deaths of 11 workers and the biggest marine oil spill in history. BP’s share price lost 50% in the immediate aftermath and total costs to the company were around US$62 billion. Avoiding companies that lack ESG credentials can therefore play an important role in protecting investment performance by limiting the risks derived from less responsible businesses.

Opportunities are waiting
The sustainability challenges we face can seem daunting, from limiting global warming to removing plastic from our oceans. However, they provide opportunities for investors, as businesses search for solutions. Xylem is a leading global water technology company at the forefront of addressing SDG Goal 6 – ensuring the availability and sustainable management of water and sanitation for all. Billions of people lack access to safe drinking water, while floods and droughts are increasing worldwide. Among its services, Xylem offers dewatering⁴ and data metering services. It is a high-quality business with strong margins, an example of the kind of company that can fit well in a responsible portfolio.

Active ownership and engagement
It’s important to remember that responsible investment is so much more than simply screening out fossil fuel, tobacco or arms manufacturers; it also encompasses an important active element of using engagement and voting powers that come with being a shareholder to actively promote improvements in responsible business practices. Managers should use their influence as stewards of capital to encourage positive change at companies through constructive dialogue and voting, helping to ensure the continuation of positive ESG momentum towards a more responsible world.

Competency means competition – sense-checking credentials
Responsible investment is evolving into the mainstream, creating competition as managers develop their ESG practices and product ranges. This can be a daunting area for trustees: the quantity and quality of information varies, with some products being repackaged as responsible – so-called “greenwashing”. Therefore, as part of the due diligence process, it would be reasonable to expect ESG factors to appear throughout an RFP document if they truly are integrated across a firm’s activities, instead of ringfenced into one ESG section.

Active ownership – the research
At a recent event, Professor Elroy Dimson, Cambridge Judge Business School, London Business School provided insights into some of the key findings from his work with Oğuzhan Karakaş and Xi Li on the impact of shareholder engagement on company behaviour and performance.

Professor Dimson’s research paper was the first published study in a top-ranked, peer-reviewed finance journal on the impact of engagement on ESG issues.

The success of engagement
The research found that large, cash rich and low capital expenditure firms are better able financially to respond to ESG factors, whereas reputational risk provides impetus to those operating in areas of high advertising intensity. Active but “non-confrontational” engagement strategies proved effective.

Engagement and performance
While the performance implications for unsuccessful engagement were broadly neutral, those companies where engagement drove change demonstrated a positive upturn in their stock market performance.

A number of factors post engagement may be at play here:

• 1. Attracting new customers and increasing loyalty, driving sales and profitability.
• 2. Increased employee loyalty resulting in more efficient operations.
• 3. Improved practices attract socially conscious investors – higher demand for shares and lower volatility in returns.

To conclude
Equities will remain a core component of pension scheme investing, and the demand to invest responsibly in this asset class will continue to grow. Not only is it now a regulatory requirement to be able to demonstrate consideration of ESG factors in pension scheme asset allocation, but trustees may not be fulfilling their financial duty as stewards of capital if they ignore ESG considerations.

The information, opinions, estimates or forecasts contained in this document were obtained from sources reasonably believed to be reliable and are subject to change at any time.

© 2020 BMO Global Asset Management. All rights reserved. BMO Global Asset Management is a trading name of BMO Asset Management Limited, which is authorised and regulated by the Financial Conduct Authority. 920689 (03/20) UK.

1. Regulation (EU) 2019/2088 of the European Parliament and of the Council on sustainability-related disclosures in the financial services sector, 9 December 2019.

2. Updated version of the Occupational Pension Scheme (Investment) Regulations 2005, October 2019.

3. From the Stockholder to the Stakeholder – How Sustainability Can Drive Financial Outperformance, (University of Oxford & Arabesque Asset Management, March 2015)

4. The removal of water from solid material or soil by wet classification, centrifugation, filtration, or similar solid-liquid separation processes.