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ESG investing in the year of the Rat

It is crucial to know what you are investing in, and better understand the different ESG solutions out in the market

With increasing concerns around green washing or ESG washing it would be wise for investors to probe deeper into the ESG solutions being presented to them.

IN this year of the Rat, interest in ESG (Environmental, Social and Governance) investing continues to grow. In our 2019 Client Insights survey, approximately 80 per cent of clients told us that they were interested in sustainable investing - and have either invested or were intending to do so.

ESG investing is focused on both protecting and enhancing long-term financial value, as well as contributing towards addressing environmental and social challenges.

As investors consider this, we bring three practical tips that we learned from observing rats for you to think about.

1. Do not always follow the herd

Rats are vulnerable to peer pressure and this usually gets them into trouble. Scientists found that rats will force themselves to eat food they find unpalatable if they know that some of their fellow rats have eaten it.

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The approach of not following the herd is one that is important when thinking about the issues you are passionate about contributing towards. There is a lot of hype in the media on sustainable investing, and people are increasingly using social media to share their views on related topics. It is important to understand the facts behind each issue and not lose sight of our personal goals in the pursuit to do good through investing.

What is important to you can be highly personal, and starting with your areas of interest is a good first step. Within the space of sustainable investing, there might be areas of environmental or social issues that you are more interested in and see an opportunity to capitalise on macro trends - from water and sanitation through to the environment, circular economy or investing in the broad sustainable development goals.

One of the misconceptions around sustainable investing is that it is driven by the 'heart' and that ESG investments underperform. This is a myth and that is why it is also important to ask questions about the financial performance of the investment. There is an increasing body of research which shows that returns from ESG solutions can be in line with traditional investments. In a study comparing over 10,000 funds between 2004 and 2018, it was found that sustainable funds provided returns in line with comparable traditional funds while reducing downside risk.

2. Ensure rat holes are addressed

An adult rat can squeeze into your home through a hole as small as the size of a quarter (less than 1.5cm!). Home owners battling with rodent issues will know that it is critical to spot rat holes in floors and walls to keep them out of their homes.

Looking at ESG issues allows us to address some of the rat holes so that risk is better managed in one's portfolio for the long term. The same research above showed that sustainable funds had 20 per cent less downside risk than traditional funds, and were more resilient in years of turbulent markets, such as in 2008, 2009, 2015 and 2018.

One potential rat hole is climate risk - which is part of the E (environment) category in ESG. The Bank for International Settlements (BIS), often described as the central bank for the world's central banks, recently warned that climate change may spark 'green swan' or 'climate black swan' disasters, which are extremely financially disruptive events that could trigger a systemic financial crisis. According to the BIS, 'green swans' present many features of typical black swans but differ in that there is some certainty that climate change risks will one day materialise and threaten more complex and unpredictable chain reactions.

The number of extreme weather events has quadrupled over the last 40 years. Only 44 per cent of the financial losses caused by those types of events are now covered in the United States. In other parts of the world, this number is even lower. For example, in Asia only 8 per cent and in Africa only 3 per cent of climate-related financial losses are covered.

Other rat holes may include ESG issues in either the governance (for example, accounting scandals and data breaches) or social (for example, sexual harassment, labour rights infringements) categories of ESG.

A 2019 study showed that ESG controversies wiped out significant value in US companies embroiled in ESG-related issues over the last five years. This analysis was done on stock prices against 24 controversies related to accounting scandals, data breaches, sexual harassment cases and other ESG issues. It found that these ESG controversies together resulted in peak-to-trough market value losses of US$534 billion as the share prices of the companies involved sank relative to the S&P 500 over the following 12 months.

3. Chew on it and dig deep!

Rats are known for constantly chewing because their teeth never stop growing! A rat's teeth can grow up to about 13cm per year and can chew through glass, lead and even aluminium.

It is crucial to know what you are investing in, and better understand the different ESG solutions out in the market so that you can chew through the clutter.

With increasing concerns around green washing or ESG washing - where an investment manager's claims of ESG integration could be exaggerated or misleading - it would be wise for investors to probe deeper into the ESG solutions being presented to them.

Since ESG is not yet a highly regulated space and there are no common standards, many funds could technically be labelled ESG as long as sufficient disclosures are made in fine print. The International Monetary Fund estimates that there are now more than 1,500 equity funds with an "explicit sustainability mandate". According to Morningstar, asset managers launched 360 sustainable funds last year, with 50 of the new offerings having an explicit climate-oriented mandate . Many asset managers are also converting existing products into sustainable funds in response to client demand.

If you are considering investing in an ESG fund, areas to gnaw at could include probing on exclusions of certain controversial sectors important to you, the sophistication of the ESG strategy of the fund, expertise of the team and how well environmental, social and governance factors are being integrated as part of the investment process.

  • The writer is head of sustainable investing and strategic engagements at Standard Chartered Private Bank

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