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ESG: the new ABCs of portfolio management?

The Environmental, Social and Governance approach offers a framework to analyse an investment opportunity from a forward-facing perspective.

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Conducting detailed safety checks and setting up proper procedures of an oil rig may initially incur additional fees or even delay projects. Over the long term, however, it provides downside protection to ensure that in critical situations, such as an oil spill, the firm can quickly resolve the issue with minimal damage to its stakeholders and avoid potential litigation fees.

INFORMED investors can be empowered investors. With the backdrop of marked advances in technology, investors now have access to a massive amount of information that is easily available at their fingertips. Coupled with the growth of social media and the democratisation of news sharing, investors are able to get instant updates on their investment portfolios.

In some cases, access to real-time, consistent and detailed company information has spurred investors to express their disagreement with corporate behaviours of their investee companies. And what is prompting this type of shareholder activism? A recent study by Ernst & Young suggests that individual investors, particularly the millennial generation, increasingly want their portfolios to reflect their personal values and beliefs. Similarly, asset owners are influencing behaviours that don't align with their vision for the future.

This was demonstrated recently when Scandinavian institutional investors pledged to withdraw investments from banks that support destructive palm oil ventures. These social dynamics are one of the driving forces behind the growing interest in responsible investing and the inclusion of the Environmental, Social and Governance (ESG) factors in private and institutional client portfolios. While not a new concept in investing, it is certainly gaining traction: in 2016, global ESG strategies accounted for approximately US$22.9 trillion in managed assets, a significant increase from the US$18.3 trillion reported in 2014.

From a portfolio management perspective, an interesting component of the ESG approach relies on its contribution to the portfolio's risk-adjusted performance. Let's consider traditional financial analysis, a process that has been highly industrialised and is dependent on the interpretation of colossal amounts of data. Undeniably, it plays an essential role in identifying how assets perform under different conditions but this backward-facing data is mainly historical in nature and, of course, future financial performance is not necessarily dependent on the historical financial data. This is where ESG analysis may present forward-facing, intangible insights that may signal a company's long-term survival and future risk considerations.

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NEW RISK FACTORS: E, S AND G

ESG provides an analysis framework for deep-dives into three pillars: Environmental, Social and Governance. These factors may have a material impact on the financial performance of the company. Unlike Socially Responsible Investment (SRI), ESG does not necessarily involve the exclusion of some sectors, such as weapons, tobacco, gambling, alcohol and animal testing. Instead, it offers a framework to analyse an investment opportunity from a different forward-facing perspective.

The Environmental pillar assesses the impact that the company's operations have on the environment and if they could potentially result in regulatory actions. It considers how a company's business activities impact climate change, pollution, water and waste management, biodiversity and habitat protection.

For example, an environmental assessment would examine if a company has proper systems in place ensuring its business operations will not cause an environmental disaster. Is the firm dumping its production waste into rivers or does it follow a proper recycling process? Is the company illegally destroying the rainforest or does it have programmes to protect environmental habitats?

The Social pillar evaluates how the firm and its business impact people through social factors like employee labour conditions, health and safety standards, employee turnover, diversity and inclusion programmes and consumer relations. For instance, the tragic collapse of Rana Plaza in Bangladesh put pressure on European and North American clothing brands to improve pay and working conditions in the factories of its suppliers. In this case, those firms that didn't follow international health and safety standards suffered reputational and financial consequences, resulting in fines and negative publicity.

The social pillar also attempts to analyse how a company's products and services impact society as a whole. For example, a nuclear weapon manufacturing company would likely have a negative impact on social well-being and, in the long term, could be impacted by consumer backlash or regulatory hurdles. With that in mind, many pension funds, foundations and endowments now exclude nuclear and biological weapon producers from their portfolios.

Lastly, the Governance pillar examines if the firm's board is structured to optimally support its business activities. It evaluates board independence and accountability, shareholder rights, transparency, anti-corruption and executive compensation factors. We've seen how poor governance practices have led to accounting scandals where management kept enormous debts off balance sheets, ultimately causing shareholders to lose assets, leaving investors reeling and destroying people's retirement funds.

Poor governance can foster an environment where management is incentivised to satisfy the aggressive growth targets above all other considerations. It can also create an atmosphere where lack of transparency can lead to significant issues being undetected for a long time. Hence, applying a governance lens to the analysis of an investment opportunity can uncover valuable insights.

It is important to note that most of these non-financial, ESG factors would hardly ever appear in the financial books of a company. In fact, they may even have a short-term financial cost but in the long term could provide a pay-off.

For instance, conducting detailed safety checks and setting up proper procedures of an oil rig may initially incur additional fees or even delay projects. Over the long term, however, it provides downside protection to ensure that in critical situations, such as an oil spill, the company can quickly resolve the issue with minimal damage to its stakeholders and avoid potential litigation fees.

Increasing evidence suggests that there is a strong link between superior ESG and corporate financial performance over the long term. Some of the findings reveal the following: "superior governance quality leads to better financial performance", "firms with high ESG scores have higher valuation" and "firms with high ESG scores enjoy better accounting and stock-market performances during financial crises".

Consequently, as investors seek to have deeper insights into risk management, ESG analysis may complement a pragmatic approach to investment portfolios by combining traditional portfolio construction supported by historical data with ESG's forward-looking assessments.

  • Juan Aronna is head of investment solutions and products Asia, and Iryna Drobysheva is associate director, ESG and portfolio specialist, RBC Wealth Management
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