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How to make the most of ESG (Ethical Investing). By Guy Myles. Capital at Risk.


The big picture

This month I'm going to provide my views on ethical, or ESG, investing because every year we see more interest in it from our clients, and it's an area that is getting a significant amount of press, due to the focus being placed on it by both Governments and regulators.

The key issue with any ESG investing is that you naturally reduce the range of investments you can make in order to achieve the desired societal impact, but this can lead to low levels of diversification and higher levels of risk. Therefore, it is important that that is managed, as poorly managed risk can lead to bad outcomes and harm.

There are also a lot of misconceptions in terms of ESG investing and the potential that people will expose themselves to unacceptable risk, therefore, this is something we need to manage.


The detail

There are three areas within ESG that can cause problems with risk control.

The first is many asset managers consider Government bonds to be unethical. Even though this is a niche view, in our opinion, it is common for ESG managers to exclude Government bonds because, in their opinion, defence spending can lead to harm. Most Government spending is not directed to defence and many people would not consider this to be inherently unethical. We are firmly of the view that Government bonds are important for portfolios because they are the only asset that is truly risk-free and often increases in value during periods when other assets fall. If you remove them from a portfolio, you significantly increase the risk without meaningfully improving ESG outcomes, and therefore we believe that this is a mistake.

Secondly, ethical constraints quite often drive people to invest predominantly in the US and Europe and ignore the rest of the world. Again, this reduces your diversification and reduces a major area in which fund managers can add value to clients by timing investments into different parts of the world. In our opinion, this reduces your potential options for return and increases risk.

The last area, depending on how you implement ESG, is that you may end up only investing in a narrow range of assets. Often ESG portfolios apply screens that mean they will overwhelmingly invest in what are known as ‘growth’ investments. These are investments into companies which are expected to grow quickly, but which tend to have higher starting valuations because investors are expecting that growth.

Many of the investments that are excluded in this process will be in the opposite and considered to be ‘value’. These are established traditional industries, which are relatively inexpensive, pay high levels of dividends, but people aren't expecting to be high growth. People sometimes believe, wrongly in our opinion, that growth investments will outperform value investments because of the growth.

A better way to look at growth and value is to view them as being of equal merit, because the prospects are accurately reflected in the price you pay today. Instead of one being better than the other, you should recognise that background factors will lead to one group performing better than the other at different times.

A look back at investment history shows that there are regular periods where growth investments do well and periods where value investments do well. Additionally you are removing a lever from your fund management to use their expertise to try and smooth out returns and improve them over time.

Implementing ESG in a way where you only invest in ‘growth’ is a mistake in our opinion, especially now as we've had ten years of outperformance from the growth style and, based on history, we are overdue a reversal to ‘value’.


The best solution

The most sensible way we see for clients to implement ESG is to invest with diversification between countries and types of investment. We think there is a way to do this that is also likely to have a strong ESG impact.

Within the energy and chemicals sectors there are large differences in behaviours between the best global companies and the alternative producers who would fill the gap if production was shifted. During the period where we try to electrify and displace fossil fuel use, we think it is everyone’s best interests to support best ESG practice within the sector.

Thinking of the world economy in this way it becomes clear to us that we should care how each sector is managed. If we want to maximise societal impact, we should try and ensure that we are influencing within all sectors. This way of building portfolios allows us to participate in all areas of the world and in every area of the economy, and to properly balance risk and to introduce levers to improve returns. It also means that your money will be used to try to maximise its influence on behaviours in all areas of the economy.

By Guy Myles. Capital at Risk.