Let us start with the following analogy: The Springboks/Proteas are not performing at their best, but they are playing England tomorrow and you believe that the English side are a much better team. Would you take a substantial financial bet with your English friends and back the South African team, regardless of your view? Do you gamble with your head or your heart?
We want to discuss environmental, social and governance (ESG) investing in this context. In essence, we think that you should be very careful of investing just with your heart. ESG is an important issue in our world, and we support the pressure it is putting on boards and CEOs who manage listed companies. However, we want people to be mindful that there are two separate issues at play. There is an investment decision, and secondly there is pressure on business leaders to consider ESG in every decision they make. As financial planners, we need to look at it in terms of the cold hard reality of a return on investment – now and for the future. We also need to carefully consider the lifestyle consequences of when you choose these types of investments.
ESG investing has undoubtedly become one of the hottest topics in investment management in recent years. As the world is changing, there is a greater requirement to understand what risks, threats, or opportunities a company faces from ESG issues. The key aspects that drive ESG factors are as follows:
Environmental criteria: These are the criteria by which an organisation manages its impact on the natural environment. Typical impacts include pollution and waste in all its forms (land, air, water), energy use, land stewardship and natural resource conservation. The consideration of environmental opportunities is also an important factor. Currently, climate change — and the move toward net-zero greenhouse gas (GHG) emissions by 2050 — dominates the agenda.
Social criteria: These criteria include the company’s stakeholder relationships and engagement, its economic vitality and social value-add, training and development, health and safety, human resources management, and community investment.
Governance criteria: These are the criteria used to determine if a company is responsibly and transparently managed. It considers risk management processes and procedures, ethics and compliance, auditing, and policies such as diversity, executive pay, illegal practices, inclusion, internal controls, and shareholder rights, to name a few. The willingness of an organisation to engage in the sustainability reporting process is another important criteria demonstrating transparency and performance in this arena.
Recently, we spent time with our associates in Kent in the United Kingdom (UK). They told us that legally they are required to provide a “Suitability Report” for their clients before they give their advice. One of the questions they have to ask a potential investor is if there are any issues they would like considered in the construction of their portfolios. Most potential clients in the UK will typically select the ESG box. But do they and their financial planner really know that their well-meaning intentions could have financial implications for themselves?
In the ideal world, investing in ESG would definitely be the way to go and something most, if not all of us, would like to do and see more of. Supporting an initiative and making a financial investment are two very separate decisions. When you invest there are a few things that you always need to consider, such as:
- Is the price I am paying for this share too high/too much?
- If the asset meets the ESG criteria, will this ESG classification drive profits and ultimately the share price over the long term?
- Have I come to the party too late?
- Has the upside of ESG investing already been included in the price?
Our alarm bells started going off when the marketing departments of major investment companies started launching ESG funds to attract new flows into their fold. On the surface, ESG investing looks great and particularly in more recent times. This is also because of the momentum of new flows chasing the same limited stocks for the past 12 years. However, this has been very concerning to us in recent years as people have bought funds for very good social, ethical and environmental reasons, but have failed to realise that many of these equities may well be overpriced. The consequence of this over the next 10 to 20 years could be life-changing for some of these investors.
If the assumption is correct that ESG investments are currently expensive, are investors in these funds aware of the risks that these investments may not give them the required returns within the ideal time frame? We all know that we should not buy something when it is expensive as our return will ultimately be lower over time. This could mean that some investors’ retirement years may end up underfunded. The impact of this is real and needs to be carefully considered.
Our concern is that these conscientious individuals may end up having to work a few years longer or look to downsize their homes a few years earlier than they anticipated. The apprehension we have is due to the fact that legislators, individuals and financial planners are so focused on improving the world, they are not necessarily considering all the potential implications to individuals. Compliance and legislation can often lead to unintended consequences.
There is another scenario, and this could be potentially underway, where asset prices have fallen substantially and many of the ESG companies have led the way. Here, ESG investing is now making more sense, provided we can see that the price we are paying is still not too high and that we are reasonably confident of good returns over the long term. In this instance, it is much easier to make an informed, rather than an emotional decision about investing in ESG funds.
ESG is making CEOs and boards change the way in which they run their companies, but the old rules of investing do not change:
- Buy low and sell high
- When making financial decisions, never let your heart rule your head.
We will be unpacking this complex issue in further newsletters
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