The relentless pursuit of better investment options - ESG investing

LAST month, in my column, I took an honest look at environmental, social and corporate governance (ESG) investing. My conclusions were:

1. Highly rated ESG companies may not generate higher expected returns;

2. Fund managers using ESG strategies may not consistently deliver higher returns;

3. Cost of implementation matters.

I also highlighted the difficulty in assessing the impact of ESG on a company, as ESG data providers use different approaches to assess ESG. Despite this challenge, we decided to move quickly and worked with our investment partner, Dimensional Fund Advisors to launch two Singapore-dollar share classes of their sustainability funds for investors in Singapore.

As part of our commitment to contribute to a better world, we put our company's treasury money and my personal funds into these two funds even before our clients started investing in them. Why this move?

Alignment with our investment framework

As a fund manager, Dimensional is honest to say that there is not enough evidence showing a consistent relationship between ESG investing and better returns. Since the investment style of the manager is material to the returns, we need a manager who invests in a way that aligns with our investment framework.

We believe that for an investment to generate long term returns, it must participate in and contribute to global economic production. Instead of investment based on market speculation, it must be based on real market return data observed across multiple economic and market cycles.

We are also convinced that an investment portfolio should be well-diversified to enhance its risk-return trade-offs. In addition, we should keep the cost of investment implementation low. The lower the costs, the higher the net return. The Dimensional sustainability offerings meet all the above criteria.

Robust and evidence-based process

Dimensional built all their investment portfolios on evidence and sound investment principles. Instead of trying to outguess markets, their funds stay invested in different sectors and countries through the best and worst of times. Instead of trying to pick mispriced securities (which most fund managers try to do), Dimensional trusts the market prices and invests in thousands of issuers of stocks and bonds (the funds are more diversified than index funds) because they believe that asset prices quickly adjust to reflect all available information, and it is futile and too costly to try to capture the mispricing.

In addition, Dimensional tilts a portion of their portfolios to small caps, value, and more profitable companies. Evidence across time and geography has shown that these companies generate a higher expected return. While Dimensional may not be the only manager who holds this philosophy, they implement it in a cost efficient and effective way over the past four decades.

The total expense ratios for the Singapore-dollar share classes of sustainability equity fund and fixed income fund are 0.28 per cent and 0.3 per cent per annum, respectively, low even by non-ESG funds' standard.

With this as the starting point, Dimensional uses ESG-related research to identify environmental risks they believe have the potential to impose significant costs on future generations. Extensive evidence points to climate change and greenhouse gas emissions (GHG) as the main culprits of environmental degradation.

So, they target a meaningful reduction in exposure to GHG emissions and potential emissions from fossil fuel reserves in their sustainability portfolios. To do that, they first obtain the Greenhouse Emissions Intensity (measured by Greenhouse Emissions Amount/Revenue) of the companies and exclude companies which do not meet the mark. The different categories of emissions are:

a) Direct emissions from operations that are owned or controlled by reporting companies. An example would be carbon dioxide emissions due to fuel burning by energy companies.

b) Indirect emissions from the generation of purchased or acquired electricity, steam, heating, or cooling consumed by reporting companies. Examples would be hotels which use a lot of electricity due to air-conditioning or data centres that consume a lot of electricity.

c) Other considerations are potential emissions (such as energy companies' reserves that they may burn in the future), oil and gas companies' toxic spills and companies involved in deforestation (such as palm oil companies).

We like this approach because ESG-conscious investors can see the actual reduction in the carbon emissions and the positive impact they are making through their investments.

One of the sustainability equity funds reduces GHG emissions intensity by 75.3 per cent in terms of tons of CO2 emissions per million dollar of sales, compared to the MSCI World Index. The fixed income fund reduces it by 90.9 per cent compared to the Bloomberg Barclays Agg Bond Index.

Enhancing investors' value

Dimensional also enhances investors' value through stewardship, especially in governance. From Jul 1, 2019 to Jun 30, 2020, they had 640 engagements with the boards of the companies they invested in on matters such as compensation/remuneration, environmental and social as well as issues on board composition.

A stronger governance practice such as improved board oversight and alignment of management and shareholder interests can improve returns and reduce risks. Through their investment process, Dimensional was able to allow investors to contribute to sustainability without sacrificing returns.

Launching the Singapore-dollar share classes of Dimensional's sustainability funds is a natural outflow of our desire to positively impact the world. We did not do it for higher investment returns but to enable clients to channel that desire without sacrificing the investment returns needed to enable life goals.

Do you notice that Singapore's weather has turned warmer in the past few years, and rain turns into a huge storm? The climate appears to have taken a turn for the worse, and scientists believe this is due to the greenhouse effect largely caused by carbon emissions. If you can contribute to a better world for our future generation without sacrificing investment returns, would you?

• The writer is CEO, Providend, Singapore's first and probably sole fee-only comprehensive wealth advisory firm. He can be contacted at chris_tan@providend.com