A primer on sustainable funds: Approaches vary

SUSTAINABLE investing has wended its way into the mainstream of Singapore's portfolio investment and advisory landscape. It has gotten to the point that, today, you would be hard-pressed to find a fund management firm that would openly admit not taking sustainability into account, in managing assets.

There are a number of reasons for the surge in interest. One, awareness of the climate crisis is by now pervasive - with good reason. The world faces a dire outlook should the global temperature rise unchecked. Following updated pledges at the ongoing COP26 in Glasgow, some experts and business leaders are hopeful that the world is making progress towards the targeted cap of 1.5 degrees Celsius.

Two, sustainability has become an avenue for investors to align their portfolios with their values. Many are keen to channel their savings into funds that go some way to make a positive difference, or at the very least, do no harm.

Three, asset managers who integrate ESG (environmental, social, governance) analyses into their portfolio investments are convinced that the discipline enables investors to mitigate risk, and even to find sources of outperformance.

Look beyond labels

As an investor, it is important to note that funds that call themselves sustainable may vary significantly in strategies and approaches. Investors who seek a sustainable exposure should make the effort to look beyond funds' labels.

A study by the Organisation for Economic Co-operation and Development (OECD) lists 6 common approaches and cautions that they are not mutually exclusive; portfolios could apply more than one approach simultaneously. The Global Sustainable Investment Alliance (GSIA) lists 7 approaches.

This list is a combination of OECD and GSIA's compilation.

• Exclusionary: This is the first and simplest approach of avoidance. The most common exclusions are typically the manufacture of controversial weapons, and avoidance of "sin" stocks such as alcohol and casinos. In a nod to the growing risk of fossil fuels, more firms are also excluding companies that derive a certain proportion of revenues from coal.

Prudential plc has made a commitment to decarbonise its portfolio of assets held on behalf of its insurance companies, with a goal of achieving net-zero status by 2050. Net zero means that the amount of carbon emitted should be in balance with the carbon removed from the atmosphere.

Prudential has committed to divest from companies that derive over 30 per cent of their income from coal. Equities are to be fully divested in 2021 and fixed income assets by 2022.

Said Yeoh El Lynn, Prudential head of ESG in Singapore: "As a large asset owner and manager, we have a distinctive role to play in the transition to a low-carbon economy. While we set decarbonisation targets for ourselves, we are also doing this thoughtfully and ensuring the transition is a just and inclusive one. Investing sustainably is the right way forward for sustainable development."

• Norms-based: This is inclusionary screening - that is, investing in a higher proportion of companies that are compliant with international norms such as those set by the OECD and the United Nations (UN). This segment may include funds invested on a best-in-class approach, where securities are chosen for a higher ESG performance relative to peers, or ratings above a certain threshold.
• Portfolio tilting: According to the OECD, this segment includes funds which tilt portfolio exposures towards issuers with higher ESG ratings, or away from those with lower ESG scores. Actively managed funds may be tilted towards areas that the manager believes could generate additional value.
• Thematic ESG: GSIA defines thematic investments as those invested in themes or assets with specific contributions to thematic solutions such as gender equity or a lower carbon portfolio.

An example is the Prulink Global Climate Change Equity Fund, an investment-linked policy (ILP) subfund that feeds into the GMO Climate Change Investment Fund, managed by GMO. The ILP sub-fund seeks to invest in companies that are positioned to benefit from climate change mitigation or adaptation efforts. Mitigation includes clean energy and energy efficiency. Sectors within the adaptation theme include agriculture and water treatment.

• Impact investments: This approach seeks to achieve measurable and positive social and environmental impacts, which are reported at least annually, "demonstrating the intentionality of the investor and underlying asset/investee, and demonstrating the investor contribution", says GSIA. Many impact funds take the 17 UN Sustainable Development Goals (SDGs) as a framework for their impact objectives.

An example is the Prulink Global Impact ESG Equity Fund, an ILP sub-fund which feeds into the Wellington Global Impact Fund. The fund has defined its investible themes in 3 major segments, aligned with the UN SDGs. These are: Life essentials which includes affordable housing and clean water and sanitation; human empowerment (which includes financial inclusion, education and bridging the digital divide); and environmental sustainability (alternative energy, resource efficiency, among others).

Wellington incorporates ESG factors into its fundamental evaluation, in the belief that companies with strong or improving ESG metrics have the potential to outperform in the long run. The Wellington fund's 2020 impact report lists a number of impacts, including the provision of education and career access to more than 328.2 million people. and the supply of over 2.4 million affordable housing units.

• ESG integration: This refers to the systematic and explicit inclusion of ESG factors into financial analyses and portfolio construction. GSIA data for 2020 shows integration has become the largest sustainable investment strategy globally with US$25.2 trillion in assets, followed by negative/exclusionary screening (US$15.9 trillion). In 2018, negative screening was the largest sustainable investment strategy.
• Engagement and shareholder action: This approach uses shareholder power to influence corporate behaviour. The avenues include direct corporate engagement; filing or co-filing shareholder proposals; and proxy voting guided by comprehensive ESG guidelines.

This front has seen major developments this year. For instance, hedge fund Engine No 1 gained 2 seats on the board of ExxonMobil, a development seen as a victory for climate advocates. Engine No 1 was backed by 2 US pension funds and some of the world's largest asset managers. Chevron shareholders also voted in favour of a resolution for the company to set more stringent targets to reduce emissions.

Yeoh said: "We work closely with Eastspring to integrate ESG considerations into our investment decisions. Active engagement is critical in the net-zero transition, which is why we have also committed to engaging with the companies who are responsible for 65 per cent of the carbon emissions in our portfolio." Eastspring is Prudential's asset management arm.

Green, or greenwashed?

Prudential also aims to measure and report its carbon footprint. It aims for a 25 per cent reduction in the average carbon intensity of its portfolio by 2025. It also aims to provide ESG ratings for ILP subfunds to raise transparency.

All these efforts bode well for climate change, but for investors there is yet another challenge - how to discern when greenwashing is taking place. Greenwashing refers to efforts to make products and practices appear more sustainable than they really are. Claims to sustainability have become so ubiquitous that some regulators have begun to take action. This is good for investors as it is far from easy to verify claims.

It was recently reported that regulators in France, Britain, Sweden, the Netherlands and Switzerland said they found a number of instances where ESG claims were not backed up. The asset managers were asked to provide more information to support those claims, or they may be forced to drop sustainability labels.

In Europe the Sustainable Finance Disclosure Regulation took effect this year, a major plank in the EU's efforts to raise transparency and help investors make informed decisions.

While the US is still mulling sustainability disclosure requirements, the Monetary Authority of Singapore has said it will set out expectations for disclosure standards for retail funds that claim to have an ESG objective by 2022. It has also said it would counter greenwashing via bank stress testing and technology to help verify the provenance of green products.