More Than a Factor Bet: The Need for Active Responsible Investment

A look at what the research – both from academics and practitioners – says on ESG investing.

 

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Introduction

Responsible investing still contends with a great deal of scepticism. One prominent argument is that it produces unbalanced portfolios, which are simply factor and sector bets, without providing meaningful alpha. The argument goes that any outperformance of responsible investment strategies up until now has simply been produced by factor rotation, and that over the long term, it may well be penalised.

We believe this view arises from an exceptionally narrow view of responsible investment. Instead, we believe that active management can allow investors to not only enhance the ethical basis of their portfolios, but that responsible investing can allow for better risk management, more adaptive portfolios and contribute to outperformance irrespective of factor rotation or sectoral performance.

Beyond the Screen: Sector Leaders, Improvers and a Balanced Portfolio

We would agree that there is an element of truth in the argument that ESG investing, if done in a slavish fashion using exclusion lists, will simply reduce itself to a series of factor and sector bets. This is because outperformance on ESG metrics is often dictated by industry: services tend to outperform industrials on the E pillar, given they are typically less energy intensive; commodity firms tend to be exposed to greater environmental risk; and construction companies have not historically been noted for their gender-balanced workforces. If we were to base a responsible investment strategy exclusively on such metrics, the resulting portfolio would largely comprise banks, health-care and tech stocks.

But while it is a grain of truth that gives strawman arguments a superficial power, like most similar arguments, this description of ESG is a caricature rather than a portrait and ignores the role that active management has to play. Sector and factor biases tend to arise due to a reliance on various forms of data which are backward looking. This results in a ‘whiter than white’ approach, meaning those companies which are improving go under the radar as missed opportunities. An active approach (through fundamental analysis) should, in contrast, discover firms which are on a positive trajectory and would earn a place in the portfolio, thus expanding the opportunity set of investments. We refer to this as a ‘leaders and improvers’ approach, and believe that there is significant alpha to be found in these transition names, as well as in those which we expect to be sustainably best in class. The resulting portfolio is one which is more balanced across sectors and factors, while having a positive impact for all stakeholders.

Practically, this method entails investors engaging with corporate management teams, including those in the worst-performing sectors. Through this, investors can encourage more responsible business practices and drive positive change across the corporate world. All things equal, the net benefit to society of encouraging energy firms or mining companies to improve their environmental performance, or to consider the needs of the communities in which they operate, is arguably far greater than that created by investing solely in firms who are already best in class, or whose absolute performance on ESG metrics is largely down to their sector.

Avoiding a Social Selloff

In addition, this factor-and-sector-bet argument completely misses the risk-management benefits of a discretionary responsible investment approach. Investors have long been aware of the link between strong corporate governance and stock outperformance, with academic literature making the connection since the 1990s.

In our view, we are now also seeing large equity price swings based on the ‘S’ component of ESG. Specific examples in 2020 would include the Nornickel scandal, in which the mining company leaked 21,000 cubic metres of diesel oil into Siberian rivers, or Rio Tinto, which destroyed the Jukkan Gorge caves in Australia to make way for an iron ore mine. The latter action caused the resignation of Rio Tinto’s CEO, and the heads of its iron ore and corporate relations divisions. Indeed, it is now imperative that investors are able to adequately analyse and manage the ESG risks inherent in companies’ operations.

A comparison of the two scandals underlines this obligation. In the aftermath of the oil spill, it emerged that Nornickel did not take the recommended steps to maintain its diesel fuel tanks. Furthermore, the firm did not report the spill for two days while trying to control it on its own. In contrast, the risks of mining firms coming into conflict with indigenous land rights and causing environmental and cultural damage was well understood by investors, and Rio Tinto had a well-established procedure for dealing with such conflicts. Its 2019 annual report detailed how the company seeks to involve indigenous groups in the “active engagement in managing and monitoring cultural heritage impacts”.¹

While Rio Tinto’s scandal was attributable to a failure to implement a pre-existing process, with the risk flagged to investors, Nornickel’s could be seen as an indictment of a business culture, which failed to comply with basic regulation.

This demonstrates how the three pillars of ESG are interlinked. That governance at Rio Tinto was superior to Nornickel means Rio’s investors were potentially better aware of potential risks, which were at least in part priced into the stock already. This may explain why Rio Tinto’s stock price move was more constrained when the destruction of the caves become known (Figure 1). The only way to manage such risks is through active discretionary management. Portfolio managers need to conduct robust research on the business models of the companies they own, alongside a clear and full understanding of the ESG risks firms are exposed to.

Source: Bloomberg; as of 30 November 2020. The organisations and/or financial instruments mentioned are for reference purposes only. The content of this material should not be construed as a recommendation for their purchase or sale.

Responsible investing as characterised by overly simplistic exclusion lists and RI screens would fail to account for these risks, since the data are backward-looking and do not undertake a thorough examination of a firm’s financial statements, nor do they involve engagement with company management to understand the strategic direction the business is taking or its risk management processes.

The Times They Are a-Changin’

As mentioned, active management allows investors to incorporate the effects of secular shifts on the RI landscape into their judgements. This becomes even more important when we consider the catalytic effect that the coronavirus pandemic has had on preexisting trends.

The pandemic has clearly placed more focus on how firms treat all stakeholders. The impact of lockdowns has put significant pressure on the profitability of businesses across industries and regions. Those companies that are failing to support or treat fairly their employees, suppliers, contractors or creditors are likely to suffer down the line. Better management teams will look to invest in and support all stakeholders, while those who do not are likely to see long-term ramifications: after the pandemic abates, they may struggle to hire the best talent because of brand and reputational risk, and could even see financial penalties or regulatory clampdowns.

One particularly pronounced shift in consumer behaviour during the crisis has been the move from physical to online retail. This poses real challenges in terms of safeguarding workers’ rights, and has rapidly accelerated over the past year. Conditions for those working in physical retail stores are typically better than those offered to warehouse workers, especially in the luxury goods sector where client service is seen as a key part of the job. While it may be attractive in the short term to cut staffing costs in a slack labour market, those firms who seek to maintain good employment terms are more likely to retain and attract the best employees. This issue is especially acute for those companies who were slow to make the necessary investments behind this shift prior to the pandemic.

Likewise, the pandemic has increased peoples’ focus on health. This is seen most obviously in the buying of sanitisers, for example, and in the Reckitt Benckiser share price. But it has also seen people forced to work from home, and to think carefully about exercise and what they consume. Given they are also being prevented from spending their money on most of their usual hobbies, national savings rates have increased materially. We believe this will play into the hands of those companies who are exposed to the health and wellbeing trends, and that if this opportunity is well used, could mark a real inflection point in the trends which supported them until now.

Covid-19 has created or exacerbated these trends, as well as others, and the full impact of this may not be seen for some time. However, observant active managers should be able to identify these future risks and opportunities and position their portfolios to capitalise on mispricings in the market. Furthermore, engaging with management teams will help to right the wrongs, and potentially throw up even more opportunities. Accounting for the effect of secular shifts allows managers to go beyond tick-box ESG metrics and identify firms that can outperform in the long term due to their embrace of responsible business practices.

Conclusion

Responsible investment is far more than a factor bet. Through diligent research and active management, responsible investment can produce a balanced portfolio, enhanced by strong risk management and sensitive to the wider forces affecting corporate profitability. Indeed, we might even go further: managers who fail to incorporate a robust assessment of ESG risk into their analysis are failing to account for a major source of alpha in the modern stock market.

1. Rio Tinto Annual Report 2019, page 66.