Posted on: May 18th, 2021
This blog shares the text of an article I recently wrote for Investment Life and Pensions Moneyfacts which they kindly published this month (May 2021).
The article explores different retail ESG and Sustainable Investment fund strategies and the ‘Divestment vs Stewardship’ dynamic.
Text as supplied to ILP Moneyfacts:
‘Stick or Twist’: exploring the stewardship vs divestment debate
As we edge towards recognising that sustainable investment strategies need to become business as usual, intermediaries could be forgiven for being unclear about relevant fund options.
Concerns can originate from not recognising the seriousness of the risks we face – or not understanding what investors can do to help solve sustainability problems.
This piece will focus on the latter, but to cover the first briefly; we now know that the planet cannot cope with the rate at which we are destroying habitats and emitting pollution, that carbon emissions are continuing to rise and that species extinctions are accelerating. We also know that social inequalities, the difference between ‘haves and have nots’, is an ever-widening chasm.
Governments are of course starting to respond, as are many businesses. The recent announcement that the UK aims to reduce emissions by 78% of 1990 levels by 2035 is part of this – as was the recent Treasury commissioned Dasgupta report on biodiversity loss. The public outcry following the death of George Floyd and fury about how some workers were mistreated during lockdown also offer signs that progress is possible.
And we know where we need to get to, not least because the UN SDGs map this out for us. Crucially, we must transition to a circular economy – where waste is eliminated and in the interest of social cohesion we need a ‘just transition’ – where everyone is afforded the respect they deserve.
But for any of this to be possible investors must help, not hinder progress. Their strategies do not need to be identical but they need to be pulling in the same direction. Sensible investor responses include: avoiding problem areas/companies (exclusions), investing in beneficial or leading companies (positive selection) and encouraging companies to change (engagement/stewardship).
All are legitimate, necessary and able to work together, but clients’ opinions vary. They are however often centred around the following ‘motivations’; a desire to change the world, a recognition that the business environment is changing – and wanting to reflect their own personal values through investment choices.
This combination of different challenges, investment responses and personal motivations is largely why strategies are and should remain diverse.
Evolving Business as Usual
At a basic level, integrating ESG (environmental, social and governance) risk into analysis is fast becoming business as usual – which is welcome. Risk mitigation is however, largely driven by relatively conventional analysis – but tends lack vision and result in only tinkering with portfolios. Core stewardship activity, such as voting shares at AGMs, has also become commonplace – but often lacks urgency. Indeed, many of the same conversations have been going round in circles for decades. Disclosure frameworks such as TCFD (companies) and the EU’s SFDR (investors) will help equip fund managers and users with the data they want – although I’d suggest that common sense and integrity should play greater roles.
For most funds however it is the activity that sits between these areas that makes them unique – which often comes down to the interplay between engagement and buy/sell decisions. Stewardship vs divestment. Stick or twist.
Serving two masters
Sustainable investment managers are ahead of the pack in recognising that they must serve two masters – financial performance and real world impacts (sometimes called ‘double materiality’). So when issues arise and there’s no documented fund policy to direct decision making the managers must make judgement calls.
So although intermediaries may want to see ‘black or white’ strategies, for active funds in particular, this is often impossible. Factors such as the ‘house view’ will be relevant, as will team expertise, the fund managers view of investee company management – and their understanding of clients’ expectations (which platforms make harder).
Exploring fund strategies
SRI Services has been working to tease out issues of this kind for over a decade and have over 100 related filter options on our free fund tool, Fund EcoMarket. But to get people started we group funds into eight (evolving) ‘SRI Styles’. For the purpose of exploring ‘engagement versus screening’ this can be reduced to four.
The first group is funds that focus on sustainability, environmental and/or social issues and themes, typically supporting companies that are helping to deliver a more sustainable future and ‘positive impacts’. Many invest significantly in ‘solutions’ companies and companies leading change and are unlikely to hold companies regarded as ‘doing significant harm’. Investors are now spoilt for choice in these areas. Examples include funds from Liontrust, BMO, Pictet, JanusHenderson, Rathbones, Stewart Investors, Jupiter, Sarasin and Partners, Triodos, M&G, Aegon, Impax and Montenaro. Although the UK situation is yet to be clarified, funds of this kind would typically fit within the EU SRDR Articles 8 and 9 descriptions.
These funds sit alongside the second group which have a greater emphasis on ‘values’ – mostly ‘Ethical funds’. Many ethical funds take sustainability every bit as seriously as themed funds – but tend to have more extensive exclusions (armaments, tobacco etc). The lines are blurred and options are fewer – but include funds from Aegon, Rathbones, Liontrust, EdenTree, ASI, Quilter Cheviot and Aviva.
For both of these groups dialogue and engagement (stewardship) activity is important – but as the funds aim to invest in ‘good’ companies stewardship is typically ‘the icing on the cake’. (These managers mostly ‘engage’ when a specific concern arises.)
The third group – tilted options – is more complicated. We split these in two: funds which focus on ESG risk mitigation (generally alongside some exclusions) which we call ‘ESG Plus’ and funds that overweight ‘more sustainable companies’ – which we call ‘Sustainability Tilted’. Tilted funds often invest across all or most sectors, including controversial stocks like oil majors and the banks that finance them – so need to be handled with care.
For these funds to add value, stewardship must be front and centre – and genuine. Where that is the case these funds should be regarded as useful for interested clients. Although they may have limited exposure to activities classified in the EU Taxonomy as ‘sustainable’, they can legitimately be described as complementing sustainability themed funds provided they are significantly focused on encourage change, for example, the transition to net zero, albeit through dialogue and voting not exclusions.
Larger asset managers tend to dominate this area – which makes sense as they have more votes at their disposal. M&G, Fidelity and BNY Mellon all have funds we class as ESG Plus. LGIM (and passive houses) offer Sustainability Tilted options.
The final group is where intermediaries need to be most careful. Funds that are marketed as being sustainable, responsible or ESG – often because they integrate ESG into their analysis or have a few exclusions (eg tobacco). We call these ‘Limited Exclusion’ or ‘toe in the water’ strategies. Again, with strong stewardship strategies they could be very powerful – but many are not there yet. Checking exclusions, stewardship strategies, resources, aims and voting records can be very revealing.
So can we see a pattern? An easily overlooked one is that movements can build rapidly, and no company wants to see either an exodus of investors or their directors unceremoniously voted off boards – so investors are relevant. Another is size. Smaller fund houses – and some newer funds with tighter remits – often focus more on innovators and solutions companies. Much larger asset managers and funds tend to lean more on stewardship.
However there are no hard and fast rules. Any manager can join collaborative initiatives such as the IIGCC (International Investors Group on Climate Change). And even funds with impeccable reputations are tested on occasions. Situations can change overnight, as they did with insulation provider Kingspan. Kingspan’s response to questioning following the Grenfell disaster was shocking. Their response led WHEB to divest – as they were rightly unimpressed, whereas Liontrust have chosen to persevere, pushing the company to improve fire safety – which, frankly, lives depend on.
When considering how to address international issues like climate change, we know that trillions will be needed (*the World Bank estimated 90 trillion USD by 2030) to finance new energy supply, transportation etc. Yet no amount of new construction will cut emissions. To reduce emissions polluters need to stop polluting – and selling a stock means a fund manager loses their seat at the table – and risks passing an investment onto a less caring new owner.
Indeed Bill Gates was quoted in the FT in September 2019 saying, “Divestment, to date, probably has reduced about zero tonnes of emissions. It’s not like you’ve capital starved [the] people making steel and gasoline…” **.
So does that mean divestment is wrong? Not at all. I’d update Bill Gates’ statement to read ‘Divestment alone will probably not deliver any reduction in emissions…’
Examples of successful major company ‘transition’ are few, but they do exist. BMO recently reminded me of Orsted – previously Danish Oil and Gas company Dong – now a world leader in offshore wind power. Sarasin and Partners often mention NextEra Energy – the US utility which is changing its business mix, driving its emissions down and the generation of new renewable energy up. Yet it is worth remembering that even newer companies, like healthy food provider HelloFresh, are imperfect, which is why WHEB are pressing them on plastic packaging and waste.
So whilst governments, standard setters and others slog it out to agree rules, labels, classifications and taxonomies – often involving round pegs and square holes – what matters most is that investee companies see that investors share the aim of deliver a sustainable future.
Over time, intermediaries may need to become both extrapolators of clients’ ESG preferences and educators. But until we know what our future rules will be a good place to start is by explaining to clients that if we are to deliver net zero, reduce biodiversity loss and address inequalities innovators need investment and existing companies need ‘encouragement’ – so both stewardship and investment decisions matter.
If we are to stop gambling with our future, we need these strategies to work together. Complementing not competing. In short – we need to ‘stick and twist’.
Founding Director SRI Services