Revolution and evolution in ESG

By Jayson Forrest - Managing Editor  - IMAP Perspectives

A roundtable of investment professionals discussed their environmental, social and corporate governance (ESG) considerations when building managed account portfolios. The discussion was led by Peter Wilson (Strategic Wealth), Deanne Baker (Lonsec) and John Woods CFA (Australian Ethical).

Melbourne-based Strategic Wealth’s foray into sustainable investing occurred about 12 months ago, following the development of its four MDA portfolios.

“After developing our four portfolios with JANA about three years ago, we quickly realised that sustainable investing was very appealing to our clients. So, we eventually went back to JANA and decided to build two portfolios with a sustainable profile,” says the CEO and founder of Strategic Wealth, Peter Wilson.

The MDA portfolios that were originally developed at Strategic Wealth were based on a Dynamic Asset Allocation (DAA) approach that included a mix of active and passive managers. When the business launched its sustainable offering about one year ago, it kept its portfolios fairly much the same; the same DAA approach, and the same active/passive balance.

However, where the sustainable solution differed was in the selection of managers.

“We approached sustainable investing by dividing it into three baskets: do no harm (which required a strong ethical filter); have good corporate citizens (which was the ESG rating); and do good (which was the impact of the investment),” Peter says.

“JANA identified the appropriate managers that would best fit into each of these baskets. By doing so, we ensured that our investment philosophy wasn’t compromised. When we talked to our clients about sustainable investing, we spoke about it as a ‘revolution followed by an evolution’. The evolution is the continuous search for better and more sustainable investments in the retail space.”  

When approaching portfolio construction for responsible investments, Lonsec takes a different view. According to Deanne Baker - Portfolio Manager, Multi Asset at Lonsec - quality research analysis underpins everything the research house does with its portfolios.

However, when Lonsec first started thinking about sustainable portfolios about two years ago, Deanne concedes there weren’t enough viable options available, particularly in the fixed income and alternatives space. But she believes this is changing rapidly, with a number of options now coming to market, particularly in the fixed income space.

“From a research perspective, some of the interesting areas that we’re seeing work done in is the credit space,” she says. “We’re also seeing quite a lot of action in the alternatives space, whether that’s global macro strategies or private equity strategies coming to market. So, I think options are starting to become available that will provide protection against equity stresses in the market.”

As for Lonsec’s ESG portfolios, the research house looks to invest with strategies and fund managers that are true to label and are serious about having a ‘real world impact’ in solving some of the world’s problems, like climate change. It also works hard to avoid those strategies and managers that are ‘greenwashing’ or claiming to be more ‘green’ than they actually are.

Deanne adds there has been a lot of product coming to market in this space over the last two years, making it particularly important for Lonsec to have the tools to separate the ‘wheat from the chaff’ and identify best-of-breed managers in terms of ESG and sustainability.

Similar to Strategic Wealth, Lonsec launched its sustainable offering about 12 months ago, which was done in response to growing client demand, particularly since the 2019 bushfires. The research house has put together a best-of-breed, multi-manager, multi-asset portfolio, and it is trying to embed ESG and sustainability across all the different asset classes because, as Deanne says: “There is little point investing in a wind farm in your equity portfolio, if your bond manager is then going out and lending capital to build a new coal mine.”  

Therefore, Lonsec is trying to take a whole of portfolio approach, by aligning its objectives to the United Nations’ Sustainable Development Goals, which consists of 17 goals covering a broad range of sustainability issues.

To be included in its portfolios, Lonsec is looking for managers to satisfy three key criteria:

• Have a ‘recommended rating’ by the Lonsec research team, which underpins the quality of the managers. 
• Show how they integrate ESG into their investment processes, including how they price in and manage the risks of ESG in their portfolios.
• Provide strategies that are sustainable.

“We have moved past the old approach to portfolio construction, where responsible investment strategies were separated from the broader peer group or more traditional funds. Instead, we think ESG is a critically important factor to consider when assessing all funds,” says Deanne.

“So, we now incorporate ESG into our ratings process, alongside people, investment process, performance and so forth. We believe fund managers should be assessing ESG risks alongside any other financial or risk metric that companies might be exposed to.”

In terms of portfolio construction, Lonsec brings all these key elements together for its sustainable portfolios by using a range of strategies, which includes best-in-class, exclusion-based, and impact investing.

“We incorporate a range of these strategies because it will take a number of these approaches to deliver on the United Nations’ Sustainable Development Goals, which our portfolios are linked to,” says Deanne.

However, the Managing Director of Ethinvest, Trevor Thomas, offers cautionary advice concerning the United Nations’ Sustainable Development Goals.

“There are many fund managers using the framework of these goals to map their impacts. But the  United Nations’ Sustainable Development Goals were never designed for fund managers, so there is a lot of impact washing that happens as a result of this, which advisers need to be aware of,” he says.

Australian Ethical has a long-established pedigree in the ethical investment space, where it has been building and running a range of multi-asset portfolios since 1986. According to John Woods CFA - Head of Asset Allocation at Australian Ethical - the fund manager’s approach to portfolio construction hinges on the work of two teams: the investment team, and the ethics team.

“It’s very important to have a consistent and ethical approach across the portfolio. When you have that consistent approach, it means you’re not unwinding the good on one side, with the bad on the other side. We have the same ethics team applying their lens and framework across all asset classes. Once this ethical scrutiny has been conducted, the investment team comes in and helps build the portfolios.”

John believes one of the strengths of Australian Ethical’s approach to portfolio construction is the transparency of its process around stock selection and asset allocation.

“Traditional asset allocation is really focused on the benchmark and alpha plus the benchmark, but when you have adopted something like an ethical, sustainable or impact approach, you’ve really moved a long way past the benchmark. So, those more traditional lenses don’t give you a good view on how the risks are manifesting themselves in your portfolio,” he says.

“Instead, you need to have a transparent view into what actually comprises the underlying asset classes and how those parts fit together, particularly in terms of risk. To manage risks, like inflation, requires you to look in different places than you would traditionally do.”

There’s no doubt that the surge in demand for ESG and sustainable investing solutions has been investor led, with clients increasingly expecting their money to be used for social good, while delivering an acceptable return on investment.

At Strategic Wealth, Peter describes some clients as being “almost religious” with their ESG and sustainability requirements. And while the majority of his clients are interested in this style of investing, Peter stresses ESG is not the ‘Holy Grail’ of investing and is definitely not suitable for every investment sector.

“For us, there are some sectors that fail our ethical screens - like tobacco, gambling and fossil fuels - that we absolutely avoid. However, if a client wants to add a screened sector back into their portfolio, then they can. That’s their choice.”

With a 30-year track record in ethical investing, Ethinvest was the first financial services company in Australia to have a dedicated focus on ethical investments. According to Trevor, the fund manager is able to accommodate the very diverse needs of its clients by providing a highly personalised service.

“This personalised service means we run about 750 share portfolios,” Trevor says. “We have introduced some model portfolios in the last two or three years that are quite popular, but when we first started, there weren’t fund managers available to build the fully diversified portfolios at the cost point we were working at 30 years ago. So, we started building share portfolios.”

However, over recent years, Ethinvest has built a range of blended portfolios of high quality, rigorously screened funds that meet most of its clients’ expectations.

“At Ethinvest, we have a very diverse range of clients. We can offer an off-the-shelf product that is rigorously screened to exclude the likes of fossil fuels and vice stocks, while being positive around environmental impact, which satisfies the appetite of most investors,” he says.

“We also attract the ‘deeply religious’ who have very strong views about particular issues, which means we have to build direct share portfolios to accommodate their needs.”  

Financial services company, InvestSense, regularly constructs portfolios for licensees, although Jonathan Ramsay - Director of InvestSense - admits it can be challenging managing the differing views and expectations of key stakeholders.

“Whether it’s licensees, advisers or investors, the problem is the same - everybody has a different view on ESG, with more problems arising around ‘greenwashing’.”

But what has been a game-changer for InvestSense was uncovering Ethos ESG. This fintech platform provides values-based investing tools, which enables businesses to better know their client, their values and investment objectives through an ‘impact assessment’ (values-based questionnaire).

The fintech also helps integrate in-depth, transparent impact data into the portfolio construction process, with Ethos ESG’s data covering over 13,000 stocks and funds, and over two million data points across 45 causes, like global warming.

“By using Ethos ESG’s values-based tools, we no longer have to obsess about our values, but instead, we ask our clients about their values. It takes the onus away from us having to be right on everything we do in the ESG space, and puts the values back onto the client. This enables us to build a portfolio and then give our clients access to the Ethos ESG tools, which allows them to measure their values against the portfolio we have constructed for them, and rate us.”

According to Jonathan, Ethos ESG offers a comprehensive database that can be used in a variety of ways. For example, a fund manager can use it to see how they rate compared to other managers, while an investor can use it to match their values with investments.

“By using Ethos ESG as an interaction tool with clients, it removes a lot of the uncertainty for us from areas that we frequently encounter, like ‘greenwashing’.”

Trevor concedes that dealing with ‘greenwashing’ is an occupational hazard when working in the ESG space. However, he points to the Ethical Fund Ratings - developed by the Ethical Advisers’ Co-op - as a tool that is helping to address ‘greenwashing’ by rating funds that have an ethical or sustainability focus.

“This ratings system has been specifically developed to assist advisers and investors make investment choices that are in line with their ethical values,” he says. “It’s a very good tool for advisers to use when building their ESG and ethical portfolios.”

In comparison, when it comes to ESG investing, the portfolio construction tool that Andrew Davies - Head of Investment Solutions at AZ Sestante - turns to is professional investment consultancy. He is currently working with Evergreen Consultants, which is doing all the heavy-lifting in understanding how each manager is approaching ESG. Andrew is using this analysis as the starting point to create his investable universe.

“Once you get to the investable universe, it’s easy to conduct the research on the managers. The hard part is understanding what the mass universe is doing in this space. So, we are using Evergreen Consultants as our solution to create an investable universe.”

According to the Global Impact Investing Network, impact investments are investments made with the intention to generate positive, measurable social and environmental impact alongside a financial return. Impact investments can be made in both emerging and developed markets, and target a range of returns from below market to market rate, depending on investors’ strategic goals.

The growing impact investment market provides capital to address the world’s most pressing challenges in sectors such as sustainable agriculture, renewable energy, conservation, microfinance, and affordable and accessible basic services, including housing, healthcare, and education. 

It’s therefore not surprising that impact investing is a style of investing that is increasingly gaining traction with Australian investors. It’s also an area of focus for Australian Ethical. But John concedes the industry is still grappling with what exactly separates impact from sustainable, ESG, and responsible investing.

“Impact encompasses the idea of ‘intentionality’, which involves setting a goal and investing capital to achieve that goal. And while we’re seeing good movement of that on the net zero front, impact investing is not an easy space to navigate,” he says.

“Many investors want to have impact with their investments, which is driving capital into this area, but we have to be mindful of what that does to the expected return and risk outcomes for some of those assets, as well as ensuring that capital is invested in a sustainable way over the long-term.”

As the economic and military rise of China continues unabated, Jonathan Ramsay accepts that geopolitical tensions do add additional complexity to the ESG, responsible, and ethical investing space.

He also cites a recent conference where a keynote speaker from Africa delivered an impassioned plea to not increase the cost of diesel to the people living in Africa.

“It was a very emotional speech, and delegates realised there is a lot of damage developed countries can do to emerging nations by trying to do ‘the right thing’ in the ESG space, which makes this a highly complicated issue to deal with.”

Deanne agrees: “There is incredible complexity involved, particularly in emerging markets. How should emerging markets pay for previous carbon emissions in the atmosphere that developed nations have largely caused? Other issues include the persecution and forced labour of the Uyghurs in the Chinese territory of Xinjiang. There are a whole range of diverse issues to consider when investing in emerging markets.”

John adds that ethical investing is by its nature, very human. “Ethical and ESG investing is not just about screening investments. Instead, people really need to debate and discuss these sorts of ‘human’ topics in-depth in order to arrive at a better understanding about their type of investment.”

Deanne Baker is Portfolio Manager, Multi Asset at Lonsec; Peter Wilson is CEO and Founder of Strategic Wealth; and John Woods CFA is Head of Asset Allocation at Australian Ethical. They led a discussion on ESG at an IMAP Specialist Roundtable event.

The session was moderated by IMAP Chair, Toby Potter.

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