Bedrock’s Newsletter for Friday 19th March, 2021

We will take a break from traditional market developments this week to address another topic that is at the forefront of investors’ minds; that is, the concept of socially responsible investing (SRI) – otherwise known as ESG investing, sustainable investing, or impact investing. As the saying goes, there are many ways to skin a cat. Regardless of your thoughts on how to name, define, or approach the topic (which we will go into later), there is no doubt that investing with reference to environmental and social matters has become increasingly mainstream. In part, this is being driven by growing awareness among many that large scale collective action is needed to tackle the biggest environmental and social challenges facing the world. However, it also the result of more and more wealth and power being transferred to a generation far more aware of these matters and willing to deploy capital to make a difference. Although it is hard to gauge the scale of this shift, you can see its symptoms on the shelves of your local supermarket – consumers are increasingly happy to pay a premium for a similar product if it can demonstrate that it has been sourced ethically and sustainably (e.g., fair trade labelling).

The rise in the supply of, and demand for, products of this nature can be seen in the investing universe. An EFAMA report published last week highlighted that the number of ESG UCITS funds in the market grew at twice the rate of non-ESG funds over the last 5 years, with assets in these ESG funds growing just shy of 40% in 2020 alone. While this is commendable and we welcome the increased focus on responsible investing, this is also new ground, and the rules of the game are yet to be defined clearly. And as is often the case when there is a new trend or target demographic to capitalise on, marketing teams can get ahead of themselves and a certain level of product misrepresentation follows. This has resulted in an explosion of “greenwashing”. The concept of greenwashing is not a new one as the term was originally coined in 1986 by American environmentalist Jay Westervelt in reference to the hotel industry’s practice of visibly promoting towel re-usage in order to “save the environment”. Westervelt noted that the underlying motive of this campaign was not environmental conscientiousness, but rather enhanced profits, a view compounded by the fact that little effort was made elsewhere in the industry to reduce energy usage or protect the environment. The term has since broadened out to encompass anything that involves spending more resources on ESG branding than on implementing policies and practices that affect those values. In the investment world, it is used to refer to strategies that focus more on marketing their SRI/ESG credentials than on integrating them into their investment process or overarching strategy. Indeed, we have seen many a long-running fund insert “Sustainable” into their name without any meaningful change to the process of security selection.

Part of the problem is that terminology in this area is poorly understood and buzzwords are often used loosely and interchangeably. Fundamentally, what is the difference between an ESG, SRI, sustainable, or impact investment? Unfortunately, everyone has their own interpretation of what these terms mean and there is no “right” answer. One way to look at it is to consider the investment objective on a sliding scale from financial gain to positive impact – on one end, are investments where there are no explicit ESG considerations and the goal is to achieve financial outperformance only (think Milton Friedman’s rather cold “The Social Responsibility of a Business is to Increase Its Profits”), and on the other end are investments where the aim is solely to generate positive impact (i.e., traditional philanthropy). Of course, there are many different approaches between these two extremes. Some strategies account for ESG factors in their fundamental analysis frameworks (“ESG”), others exclude certain sectors or follow a “best-in-class” approach within sectors (”SRI”), and still others aim to generate a positive impact and competitive market returns at the same time (”impact”). Of course, we would argue that you cannot really separate ESG factors from financial returns at this point – any serious investor should be taking ESG factors into consideration, as those who do not risk falling afoul of consumer boycotts, government fines, or changes in the regulatory landscape among other things. Not doing so is simply failing to do your job properly as an investment manager today. As such, while it is not necessarily misleading for most strategies to be labelled “ESG”, the majority should still be distinguished from those strategies that attempt to drive genuine positive impact in the world. This is where greenwashing becomes an issue, as it can become difficult for investors to discern the difference in a sea of “Sustainable ESG” funds, and capital destined for positive impact can be siphoned off into more traditional investment strategies.

The Sustainable Finance Disclosure Regulation (SFDR) just introduced by the EU is an effort to tackle this greenwashing problem. The SFDR provides a standardised framework that improves transparency around the sustainability of financial products, reduces the prevalence of greenwashing, and improves the comparability of products for ESG-conscious investors. There are many aspects of the legislation which will be phased in over a number of years, but of particular relevance to this discussion is the classification requirements (as of 10/03) for products that are marketed as being ‘ESG’. Those products that promote environmental, social, or governance characteristics are now to be classified as Article 8 compliant, while those that have “sustainable investment” as their objective will be considered Article 9 compliant. Compliance with both Articles requires managers to report certain metrics to support their claims. Now, this framework is far from perfect – there is a certain amount of self-reporting apparent and the disclosure requirements are unclear and likely to be delayed – and it certainly does not preclude the need for investors to conduct their own due diligence. For an anecdote on the pitfalls of relying on an external body to do the work for you, we suggest that you look no further than Refinitiv’s ESG rankings of the FTSE 100. Here, you will find British American Tobacco and Glencore among the top 5 companies with the highest score. Refinitiv certainly have reasons for this – BAT is working towards making its operations carbon neutral by 2030 and has launched a comprehensive programme to promote the sustainability of its sourcing, while Glencore is targeting net zero emissions by 2050 and has transparent and well-aligned incentive schemes at the executive level – but many would find the fundamental nature of these businesses at odds with their own view of “ESG”. Nonetheless, something is (usually) better than nothing and we believe that the rollout of the SFDR is a step in the right direction.

Lastly, we would like to point out just how interesting the current investment environment is for those looking to make the world a better place. The holy grail of impact investing is an investment that generates both a genuine positive impact and market-beating returns. Historically, this was something of a mythical beast, which largely explains why impact investing has existed at the periphery of the financial world for so long – it was considered more the domain of philanthropists than serious investors. However, this is no longer the case. A perfect storm – shifting consumer demand, government policy, and dramatic technological advances – driven by the need for us to change the way we treat our planet, and its inhabitants, has created a rather unique scenario where many of the highest growth sectors of today’s economy are also those that are also tackling the myriad social and environmental challenges facing us all. Whether these are sectors enabling the clean energy transition, extending the product lifecycle, facilitating universal access to credit, enhancing our ability to communicate with each other, or aiming to explore space, there are no shortage of compelling investment opportunities with equally compelling narratives. We can only feel excited by the long-term prospects here, however cautious markets might make us in the short-term.

On this subject, we would also like to inform our readers that Bedrock has recently become a signatory of the UN Principles of Responsible Investing (PRI). As we progress further on this journey, we will be formalising our approach to responsible investments to ensure that it aligns with our values, while providing sound ESG investments for clients.