Ethical investing comes of age – The Australian Financial Review

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Responsible investing is viewed as “new-economy” investing.

by Tony Featherstone

Green is the new black in investing as billions of dollars pour into ethical funds and a rush of financial products with environment and social themes targets mainstream investors.

Ethical fund assets grew 62 per cent in 2015 to $52 billion, shows the latest Responsible Investment Association Australasia (RIAA) Benchmark Report. The sector has doubled in two years as responsible investing redefines the investment landscape.

“There’s been a massive awakening in ethical investing,” says RIAA CEO Simon O’Connor. “Investors have realised they can invest in a way that helps rather than harms the planet, without sacrificing returns. We are rapidly heading towards a ‘tipping point’.”

Growth is being driven by a new generation of investors who are aligning their investment values with personal values; the consistent outperformance of ethical funds on average; and belated recognition that ethical investing reduces portfolio risk.

“It is well established that companies with better environmental, social and governance (ESG) practices are more sustainable and deliver higher returns over time,” says O’Connor. “Investors are voting with their feet. Growth in ethical investing has a long way to run.”

Ethical investing and ESG, although they are related, are different concepts. Ethical funds avoid harmful sectors; ESG, a more holistic investment approach, integrates ESG principles into portfolio decisions.

Ethical investing, technically described as core responsible investing, accounted for 3.8 per cent of total assets under management in 2015. After hovering between 1–2 per cent for years, ethical investing’s share of managed funds is soaring. Although official 2016 figures are yet to be tallied, ethical investing has, anecdotally, had a boom year.

Industry insiders believe the sector will double within three to five years. If that goal is met, roughly another $50 billion will flow into ethical funds, attracting 700,000 new investors (based on an average managed fund balance of about $70,000 in some ethical funds).

Longer term, core responsible investing is expected to account for 10 per cent of all professionally managed assets – or about $134 billion on 2015 numbers.

“We have always believed that ethical investing will come of age and be part of the mainstream rather than a fringe sector,” says Australian Ethical Investment managing director, Phillip Vernon. “It’s happening. People no longer believe the myth that they have to make sacrifices on portfolio returns when investing in ethical funds.”

Vernon believes up to 10 per cent of the Australian investing public, or 1.5 million people, have high ethical convictions that will drive their investment behaviours. “There’s a rising social consciousness in the way people consume goods and a growing sense of empowerment as more people express themselves through the way they invest.”

Fund managers are lining up to seize the opportunity. Sixty-nine asset managers offered ethical or socially responsible investment products in 2015, from 29 a year earlier. And many superannuation funds have upgraded their ethical investment options to satisfy member demand.

Lower-cost offerings

Exchange-traded funds (ETFs) are entering the fray. BetaShares in January launched the Global Sustainability Leaders ETF (ETHI) on the ASX and UBS has several ethical ETFs over global sharemarket indices that exclude tobacco and controversial weapons stocks. Russell Investments in April 2015 launched the Russell Australian Responsible Investment ETF.

The arrival of ETFs in ethical investing is telling. This style of investing traditionally suits active fund managers who spend extra time assessing the ethical credentials of companies, in addition to their potential returns.

Ethical ETFs remove an impediment to investing ethically: higher fees. ETFs, generally, are expanding rapidly in Australia as more investors favour lower-cost “passive” products that aim to mirror the return of an underlying index or strategy.

“We expect strong growth in ethical ETFs on the ASX,” says BetaShares managing director, Alex Vynokur. “The launch of ETHI on the ASX, which adopts a rigorous ethical investment approach, delivers proof that ethical investing does not need to involve high fees. It can be done just as effectively through ETFs, with transparency and at far less cost.”

Listed investment companies (LICs), a form of listed managed fund on the ASX, is another new option for ethical investors. The Morphic Ethical Equities Fund raised almost $50 million in an initial public offering (IPO) and listed on the ASX in early May.

Morphic is the second ethical LIC on the ASX, joining Hunter Hall Global Value LIC. Hunter Hall International in March announced a merger with Pengana Capital, in a deal orchestrated by Washington H Soul Pattinson, an investor in the coal sector through its 59 per cent stake in New Hope Group.

Morphic Asset Management managing director Jack Lowenstein, a leading ethical investor who helped build Hunter Hall’s peak $3 billion asset base, saw an opportunity to launch a new LIC.

“The LIC structure appeals to people who want exposure in ethical funds directly and may not have a lot to invest, so are not viable clients for financial planners,” he says. “We believe ethical LICs can take ethical investors to a wider audience, including younger investors.”

Morphic’s mandate allows the short-selling of companies with poor ESG performance – a controversial move that enables the LIC to profit from investment activity in companies that are seen to act unethically should their share price fall.

“This feature undoubtedly cost us some investors,” says Lowenstein. “But we believe the market will inevitably come to us on this issue. Effectively, we can use short-selling of companies with poor ESG practices to help fund investments in companies with good ESG. That will support our goal of higher returns and lower volatility in the LIC, over time.”

Ethical ETFs over fixed interest and other asset classes is another emerging development. It’s understood Australian ETF issuers are considering launching ethical ETFs over local and international fixed-interest indices.

Ethical investing has so far mostly focused on equities. Now more investors want to know that fixed and floating-rate securities are issued by companies with sound ESG practices, from non-harmful sectors. Ethical funds over property securities are another possibility as investors favour buildings with higher environmental ratings.

RIAA’s O’Connor says: “A wider spectrum of ethical investment products is coming to market. It will range from ‘light green’ to ‘deep green’ products that allow people to invest according to their level of conviction and extend across asset classes. There will also be a dramatic shift in industries that fund managers invest in, as they respond to investor demand to avoid industries they are not comfortable profiting from.”

Factors driving growth

Nathan Lim, executive director of Morgan Stanley Wealth Management and an ethical investing expert, says generational change is driving growth. “Younger investors, in particular, are engaged in the broader narrative of how one’s day-to-day activities, including investing, affect the planet. They realise it makes no sense to have solar rooftop panels to help the environment, yet invest in fossil-fuel companies through their super fund,” he says.

“It’s no different to someone favouring free-range eggs or fair-trade coffee at the supermarket. Those values are being reflected in financial markets by a more informed, engaged investor base that no longer tolerates funding unethical companies.”

Lowy Institute polling has shown consistent growth since 2012 in the number of Australians who believe climate change is a serious, pressing problem. Just over half of Lowy’s survey respondents now hold this view, from a low of 36 per cent in 2012 – a trend that bodes well for growth in ethical investing.

Returns are the second factor driving the ethical investing boom. New evidence is emerging that ethical funds achieve higher returns – a message that is getting to investors.

Core responsible investment Australian share funds outerperformed the S&P/ASX 300 index and average large-cap Australian equity funds over one, three, five and 10 years to the end of 2015, RIAA data shows. Sustained outperformance is rare in active funds management, where the majority of funds underperform their benchmark index over long periods.

Some active ethical funds have top returns. The Generation Wholesale Global Shares Fund delivered a 20 per cent annualised return over five years to March 2017, Morningstar data shows.

Australian Ethical Investment, manager of several ethical funds, has a five-year annualised total return of 39 per cent, making it one of the market’s top small-cap stocks.

Ethical funds globally are outperforming. A Morgan Stanley Institute for Sustainable Investing study of more than 10,000 mutual funds found that sustainable equity funds met or exceeded median returns of traditional equity funds during 64 per cent of time periods examined.

The authors wrote: “Investing in sustainability has usually met, and often exceeded, the performance of comparable traditional investments. This is both on an absolute and risk-adjusted basis across asset classes and over time.”

A body of academic research confirms higher returns from sustainable investing. In 2016, Harvard University researchers Sakis Kotsantonis, Christopher Penney and George Serafeim wrote: “Companies committed to ESG are finding competitive advantages in product, labour and capital markets, and portfolios that have integrated ‘material’ ESG metrics have provided average returns to their investors that are superior to those of conventional portfolios, while exhibiting lower risk.”

The upshot is ethical investing is emerging as an unlikely source of alpha (a return higher than the market return) as the weight of money gradually flows towards companies and industries with stronger ESG credentials and away from the laggards.

Portfolio risk reduction is the third factor boosting ethical investing. Rampant growth in shareholder activism worldwide is targeting companies that act unethically. Those with poor ESG performance are prey for activists to force change, often driving share prices lower.

Every Fortune 500 company in the United States now has at least three activist firms, mostly US hedge funds, looking for chinks in ESG or earnings performance that can be exploited.

“We view ESG investing as best-in-breed investing,” says Morgan Stanley’s Nathan Lim. “Investors recognise there are more risks to a company than only earnings risk, and that companies and industries that have good ESG practices tend to exhibit lower volatility over time. By incorporating ESG analysis on top of financial analysis, investors are taking extra steps to reduce risk and protect their portfolio.”

Lim sees responsible investing as “new-economy” investing. “You’re putting your money in growth industries, such as renewables, and avoiding industries with challenged prospects, such as fossil fuels, tobacco, weapons and other controversial sectors,” he says. “If you can achieve higher returns at lower risk, while investing in growth industries of tomorrow, you’ll favour responsible investing regardless of what type of investor you are.”

Ensuring portfolios are on the right side of the ESG divide has never been more important. Westpac Banking Corporation’s decision in April to rule out financing Adani Group’s coal mine development in Queensland’s Galilee Basin is symptomatic of the pressure on financiers and large investors to review their climate change policies.

The Australian Prudential Regulation Authority in February warned financial institutions that climate change must be viewed as a risk-management issue.

From a board perspective, risks associated with climate change have evolved from “ethical environmental” to material financial issues, meaning company directors who fail to grapple with them are potentially legally exposed, according to some legal opinion.

It is unclear how far, or how fast, public pressure on corporate ESG standards will spread to other sectors.

Tobacco, weapons, pornography, fossil fuels, nuclear energy and high-polluting sectors are obvious areas for ethical funds to avoid. But market pressure on gambling, alcohol, junk-food and sugar stocks could rise if shareholders believe they cannot influence how these sectors respond to social problems, such as addiction and obesity.

Companies with repeated human-rights and supply-chain violations could also be screened out of ethical funds, as could countries that enforce mandatory detention of asylum seekers (in terms of geographic funds allocations in global funds).

Whatever happens, investors must ensure their portfolio is stacked with companies and industries with sound ESG practices, to get ahead of this trend.

The fourth factor driving ethical investing is the removal of industry bottlenecks. As superannuation funds show greater interest in ESG performance, more fund managers are incorporating ESG data into their investment analysis. This is forcing large stockbroking firms to produce detailed company ESG analysis and underpinning growth in a new industry of external ESG data providers and analysts.

At the same time, ASX-listed companies are publishing more ESG data, through their sustainability reports, for investors. Fund managers, for example, can assess the occupational health and safety performance of a mining company to analyse its risk-management processes, approach to staff and culture. A declining safety record and rising employee turnover might signal ESG risks and poor management.

These trends, underway for a decade, have quickened in the past few years as companies, fund managers, financial intermediaries and investors pay extra attention to ESG data.

The intersection of these forces should mean more money flowing into ethical funds, more managers entering the sector and a wider range of product that provides a spectrum for investors to choose the level of ethical investing that matches their conviction. Greater scale in ethical investing should, in theory, lower fees.

This trend could also lead to funds that incorporate ESG principles excluding sectors considered harmful (such as tobacco) – and start to look a bit more like ethical funds.

The risk is the boom attracts too many managers who latch on to demand for ethical funds by launching “light green” products that do meet ethical investing standards.

The emergence of long/short ethical funds (buying companies with good ESG practices and short-selling those with poor ESG) is another complication. So is the rise of ethical global ETFs that are stacked with US technology stocks that rate well on ESG criteria.

As with any financial product, it pays to understand the detail before investing. Knowing what the ethical fund owns, its investment mandate, personnel and record, is critical. Investors with deep convictions might find they invest in new-style ethical funds that do little more than replicate the main sharemarket indices – for unnecessary high fees. They may also find that not all ethical funds are ethical.

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