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A global survey published in May of 2017, conducted by BNP Paribas Securities Services, found that, among the 80% of respondents who self-identified as ESG-incorporators, nearly half of asset owners said they planned to double their allocation over the next two years; up to 50% of assets. Obligingly, asset managers said for their part, they would double the number of funds labelled as such in the same period. Responders were split relatively evenly across APAC (29%), Europe (38%) and North America (33%). It is always prudent to apply a hefty haircut to good intentions. Even so, this is an extraordinary finding that should stop any fund manager Head of Business Development in their tracks.
But what is actually driving the demand in sustainable/responsible investment? What are the trends for the next three to five years? What are the pitfalls? What are the super-factors driving the proliferation of funds, benchmarks, standards and initiatives, and are they themselves sustainable?
I see five dominant and inter-related factors that make sense of what is happening in the market.
1. Mainstreaming is going mainstream
In the last two years, we have seen a preference not so much for new, multi-billion dollar labelled funds but instead, a mix of conversion of existing funds and other forms of re-allocation of capital to ESG strategies. In 2017 Swiss Re stunned the market when it said it would benchmark all of its €130bn AUM against ESG indices. It looked to some like a ‘statement’ but reflect, for a moment, that it was taken by a business culture that lives and dies by risk management. Zurich recently committed to double its allocation to responsible investment strategies while US giant Legg Mason reckoned the proportion of its assets characterised as ESG linked was 25%. Another long-standing US house, Putnam, took two large mainstream funds ($5bn intotal), re-enforced the structure with ESG factors and re-labelled them ‘Sustainable’. I imagine existing clients did not blink and Putnam must be confident about attracting new ones. The Government Pension Fund in Japan is in the middle of a $27bn ESG tender and Taiwanese Government pension funds have made multi-billion allocations to ESG strategies, often with ‘new money’; so it is not simply a capital recycling story. Legal & General Investment Management has attracted climate-conscious pension funds to its climate tilted Future World Fund, more than doubling in value in a year since launch, to £4.6bn. It is not all passive, either. In April 2017, French civil service pension fund ERAPF made a €4bn long-term fundamental active ESG mandate, split between 7 investors.
2. The data is finally nearly there
Why this unleashing of serious money, at last? One reason is there is simply greater comfort with ESG (the non-ideological, analytical approach) as supportive of superior investment outcomes. This has been demonstrated convincingly in study after study by investment banks and academics, alike. Recent examples include HSBC, BofAML, McKinsey, showing inter alia: higher revenue growth, higher market capitalisation, higher Return on Equity and lower volatility. Aviva Investors has produced a useful summary of similar studies.
This is not another puff piece about the transformative power of Big Data. ESG has been content building on Basic Data, now provided courtesy of some of the most influential rating agencies and financial terminals. For years, Bloomberg has enabled their ubiquitous terminals to produce clever ESG data (at no extra charge). Moody’s and Standard & Poor’s have launched their respective green bond certification programmes and the latter its ESG ratings, not as a standalone but explaining how pertinent ESG factors could affect the financials.
3. Product: securitisation and data offer new choices, liquidity
Conversion of existing funds to ESG is helpful, but not enough, for example, to meet the estimated requirement of an extra $1trn of capital flowing into climate-friendly infrastructure to meet the Paris Accord target of limiting warming to less than 2°C. For years, ‘securitization’ was talked of as the missing piece between where we were and where we needed to go in order to make finance flow to more sustainable outcomes; be it in challenging the market failure of climate change or delivering benefits to the Bottom of the Pyramid: the 4 billion people estimated to be living on less than $2.50 per day. We can say now that securitisation is underway, and it is forming, recognising and categorising the assets in all classes on which new and altered investment products can be built. The timing of other factors has helped. The cleantech space and green bonds finally became of investible age at a time when commodities plunged into another white-knuckle ride and renewables saw a spectacular fall in price. New, disruptive tech sectors experiencing phenomenal growth have been popular with ESG funds. The market for Green Bonds has grown exponentially in just a few years since creation. Also popular are Social Bonds, which like Green Bonds, may be dedicated for public good uses or have social targets to achieve, especially with the Third Sector. A sub-trend, Impact Investment, sets out to identify, target, measure and achieve non-financial goals (such as better educational attainment among the rural poor) as well as deliver a stated return. Usually in the form of debt, private equity and other alternatives, the impact frequency on the Spectrum has attracted huge interest from, among others, global investment banks like UBS, Credit Suisse, Bank of America, Barclays and Deutsche Bank. They see the opportunity to draw on their deep pool of HNWs/UHNWs and convert tens of billions of that flexible wealth away from straight philanthropy intoenlightened capitalism, while basking in the reflected glory. There is encouraging evidence that, contrary to expectations, returns mirror a normal distribution for their plain vanilla equivalents. A recent variation on Impact are products based on the 2015 United Nations Sustainable Development Goals (SDGs), 17 targets on diverse issues including zero hunger and responsible consumption and production. Most MNCs, Financial Institutions included, have signed up to the SDGs at plc level, so there are synergies for product development. ESG has been swept up in the ‘Rise of Passive’, too. There has been a barrage of ESG indices for every taste: water, climate, emerging market leaders, diversity champions, and so on. DJSI recently announced additions to its stable of 150 sustainability indices, in response to client demand, it said.
4. Regulation: more helping hand than dead hand
Securitization is being propelled by a governmental and multi-lateral led push for financialisation of the Green Economy. For example, the European Commission supports the High-Level Expert Group on Sustainable Finance’s (HLEG), which has proposed a controversial Green Supportive Principle; that banks should have their capital adequacy requirements relaxed in exchange for mobilising qualifying ‘green capital’. In addition to being essential to meeting complex policy goals like decarbonisation, governments are keen on the hybridisation of finance and the delivery of public goods, in part, to plug holes left by austerity.
Soft law and voluntary standards will continue to carry serious weight. Mark Carney’s Taskforce for Climate-Related Disclosure’s (TCFD) report, considered primus inter pares, set out expectations for disclosure on climate change governance, scenario planning, risk management and metrics. They are applicable to all companies, asset managers included, and are expected to bleed into generally accepted accounting principles in coming years. HLEG’s priorities include sorting
out what qualifies as sustainable; both for retail customers and in support of supra-national policy goals like decarbonising the economy. For the oft-neglected retail market: labelling and standards, even the possibility of an ISO standard, will be developed.
5. Transparency: “Trust me” to “Show me”
A chill wind blew through the asset manager world when Morningstar bought a 40% stake in ESG ratings company Sustainalytics and at a stroke produced 34,000 funds sustainability ratings. The ratings take no heed of glossy brochures, soothing platitudes, or even elaborate diagrams. No. The rating depends on the ESG ratings of what you invest in. MSCI, Lipper, and BNP Paribas Custodial Services have launched similar ratings. This has provoked legitimate chagrin, with some arguing that reliance on often crude ratings used so widely does a disservice to research processes that are much more discriminating, intelligent and context-sensitive. The same criticism can be levelled at ESG indices. Asset managers should not fear fund ESG ratings, which should come with a health warning. Portfolio managers should be ready to defend their holdings on sustainability grounds or if they cannot, ask themselves why? Clients and their consultants should probe whether the arguments hold up or are self-serving. Long overdue, the honeymoon period for PRI signatories is about to end, with a promise to bottom-slice the free-riders and box-tickers The PRI, since foundation, has been tactically non-judgemental and taken a ‘let a thousand flowers bloom’ attitude. A corollary of this has been an assessment focussed on process, rather than outcome, an unfortunate side-effect of which is the gaming the process, in some quarters, leading to unrealistic grades. There is disquiet in the industry. Now that the PRI has demolished the taboo on Responsible Investment, it is time to focus on quality over quantity: outcome as much as process.
Investment consultants are to be brought under regulatory ambit and expected to step up on fiduciary duty, by proxy. The best are already adept at weeding out asset managers with more form than substance on ESG. Expect to be able to prove how all these lovely processes make any difference: whether that’s an adjustment to your DCF or something bigger.
Eurosif reports show that since 2002, AUM covering a range of Responsible Investment strategies (including mainstream integration) experienced high double digit CAGR over each two-year assessment period, higher than the market as a whole, albeit from a lower base.Growth barely slowed during the financial crisis. About what other trend can you say that? Net headcount in the industry kept growing and is going through a new expansion.
In 2011, fully three quarters of studies I could find on the financial impact of ESG strategies found positive correlation with higher beta, and often with higher alpha. The remaining quarter was split between negative correlation and ‘inconclusive’. These trends have only accentuated since then. A note of caution: the market, especially in terms of products, looks quite frothy in a way not seen before. Many of the products that have been launched look opportunistic, me-too and sub-scale. With the market potentially over-supplied, many will underperform. That is not automatically a reflection on the inherent value proposition of Responsible Investment. That is just how markets are when something becomes fashionable. What becomes fashionable becomes unfashionable, some will reasonably object. Except that, too, would be a superficial reading. Look at the long-term fundamentals once the froth is blown off.
Here is a re-cap:
a) The adults in the room have endorsed it: Mark Carney, Michael Bloomberg etc. There is a queue of major-league asset manager CEOs forming to deliver the keynote at the main industry conferences that draw attendees in their thousands.
b) The longitudinal, empirical evidence for enhanced long-term performance is highly supportive.
c) Politicians are behind it.
d) Institutional investors and the general public, especially millennials want it; with the caveat that it must not hurt their pocket: but for that, see b).
e) An era of professionalization and accountability is on the horizon.
In short, responsible investment in the early 21st century is a self-reinforcing cycle. These foundations are driving demand, mainstreaming, data, product innovation, and an atmosphere of increased transparency. They have created an investment theme that has grown dramatically yet resiliently over two decades. And yet, so much remains to be done: sustainability has never been higher profile nor the challenges so daunting. That is good news, for some. The reasons to be a long-term bull about responsible investment, and the ability to monetise it, have never been more powerful.
Niall O’Shea is Director at Discern Sustainability