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05 Oct 2020
Integrating ESG factors into a diversified portfolio
Lessons learned from a pandemic.
The Covid-19 pandemic has served as a reminder of how suddenly events can overhaul the investment landscape and impact the performance of even the most well-positioned portfolios.
In times of crisis, however, often come opportunities for reflection. Covid-19 has pulled back the curtain on other shadows which cast themselves over our way of life, such as global inequality, social injustice, and climate change.
The rise of ESG investing
As custodians of wealth, we find our roles evolving from conventional investment management to also providing our clients with a tailored solution which integrates the basket of sustainability factors commonly referred to as ‘ESG’: environmental, social and governance.
This speaks to the heart of our clients not only looking to protect and grow the real value of their wealth but also to “do the right thing” when investing. At Investec Wealth & Investment, we share our client’s passion for doing our part in shaping a better world for future generations and we have embedded ESG at the heart of our stock selection process.
ESG is not “one size fits all”
ESG investing is not a new concept but it can be interpreted in different ways by individuals who hold different values and opinions on what business activities should be avoided and which supported.
For example, resource mining companies engage in carbon-footprint intensive extraction methods, but the minerals provided to the market are essential for our evolution to more energy-efficient ‘smarter’ technologies, such as the electric vehicle revolution. To our clients, we recommend the first step towards implementing a unique ESG strategy is to have a sensible conversation and engage with these issues from a practical standpoint.
Debunking ESG myths
There is a commonly held misconception that ESG necessarily leads to poorer performance by excluding those cash-generative sectors such as oil and armaments that have historically formed the backbone for many client portfolios.
To help debunk this myth, there is a compelling tracker fund released just last year, the ‘S&P 500 ESG Index’, designed to replicate the performance of the S&P 500 (the most commonly followed index for US equity representing 500 large-cap listed companies) by only using ESG qualifying companies. At the time of writing, it has delivered a hypothetical (if we back-test the methodology used) annualised return of 12.20% in US dollar terms over the last 5 years, compared to 11.45% from the main index. (Source: https://www.spglobal.com/spdji/en/indices/equity/sp-500-esg-index/#overview).
The important message here is that ESG investing for the greater good can also be good for returns.
ESG as a performance driver
Outperformance by ESG companies can be attributable to many different things, not least of which is the motivation to improve the world can often draw the best from company directors, the loyalty of their customers and can help avoid a controversy through the eyes of an increasingly unsympathetic public.
We take the view that running a company without a clear and demonstrable ESG policy is systemically bad for business and represents a risk to future company cash flows that needs to be considered similar to any other established metric.
An interesting publication from Societe Generale examined the impact an ‘ESG Controversy Event’ can have on stock performance. This study found that not only did such controversies halt any further stock price advance, but two-thirds of the time a share impacted by such an event will underperform the broader MSCI World Index by 12% and their regional sector by 4% over the subsequent 2 years. Clearly, there is a benefit to integrating a process that favours stocks with a strong ESG profile.
ESG screening and integration
To help our clients navigate an increasing emphasis on ESG by the investment community, we use a world-leading, third-party specialist ESG screening provider.
We also have the scope and advantage engrained by our international heritage to broaden our perspective away from domestically-listed stocks, with a dominance of banks and resources, into more internationally-focused portfolios including world-beating technology shares which have thrived throughout the current crisis.
For clients wanting a truly bespoke option, we can also target specific causes and avoid sectors to better reflect their values. This is often an essential objective for charities that want to use portfolios to further their positive cause, prevent harm, and avoid inadvertently supporting a controversy.
When all is said and done, incorporating ESG can help shape the behaviour of business and ultimately a better world for future generations. We find it comforting to see the same passion which drives our clients to seek a positive impact from their investments can also lead us to better portfolio construction and long-term outperformance.