By Jayson Forrest
Investor interest in responsible investing continues at a steady pace. But despite this interest, this type of investing is not without its challenges. Adam Myers (Pengana Capital), Nathan Fradley (Ethos Impact Australia), John Woods (Australian Ethical), Tony Adams (Lonsec), and Dr Danielle Kent (The University of Sydney) explore some of the challenges of responsible investing when constructing portfolios
There’s no denying that as investors seek to make a tangible and beneficial social difference in the way they invest, while making a return on their investment, the interest in responsible investing continues to gain traction amongst people.
According to research from the Responsible Investment Association Australasia (RIAA), findings in its 2023 Responsible Investment Benchmark Report found that investors are looking to invest in companies that can demonstrate ESG leadership or best-in-class status. Almost $40 billion was allocated to these investments in 2022, with impact investments almost doubled compared to the previous year – up from $30 billion in 2021 to $59 billion in 2022.
RIAA values Australia’s responsible investment market at $1.3 trillion in 2022 (accounting for 36 per cent of the overall market), with money flowing to outcomes that beneficially impact both people and planet. Investments into sustainability themes increased substantially in 2022, reaching $235 billion (up from $161 billion in 2021).
Speaking at an IMAP Independent Thought Roundtable (in association with Pengana Capital) on responsible investing, Nathan Fradley — Co-Director of Ethos Impact Australia and a Senior Adviser at Tribeca Financial — believes the growing awareness of responsible investing reflects the strong opinions people have on a range of issues, particularly in relation to how they use their money for social good.
Adam Myers - Pengana Capital
Dr Danielle Kent - The University of Sydney
John Woods, CFA - Australian Ethical
Nathan Fradley - Ethos Impact Australia
Tony Adams - Lonsec
What is difficult in constructing ESG portfolios is you have to look for ways to be rewarded for the tracking error you take, like the unintentional biases that, say, a value manager has. So, you want to be very deliberate about the differences in your portfolio and ensure you’re being rewarded for them
The challenges of uncertainty
However, despite the interest in responsible investing, 2022 did bring a new set of challenges for investors, with the Australian total (consolidated) managed funds industry finishing the year $40 billion lower than in 2021, as the global economy slowed in 2022. This was also reflected in the underperformance of the responsible investment sector.
“This period of underperformance was due to a range of factors,” says Adam Myers — Executive Director at Pengana Capital. “We saw a concentration of performance in only a few sectors, like energy stocks and weapons manufacturers, which resulted in investors facing tracking error.”
However, Tony Adams — Head of Sustainable Investment Research at Lonsec — challenges the premise that responsible investing has underperformed. “It all comes down to your definition of responsible investing,” says Tony. “If responsible investing means you’re only going to buy wind farms, but then Russia invades Ukraine, then ‘yes’, you’re going to underperform.
“But if your idea of responsible investing means you’re going to make sure you get paid for the risk you’re taking — which is your standard ESG integration approach — then it’s unlikely you’re going to underperform. That’s because you will have a better perspective of the risks companies face, which allows you to price these companies better.”
According to Tony, if you understand the ESG risks that a company faces and price them properly, then over the long-term, investors can’t help but outperform. He adds that Government policies worldwide are attempting to support the UN’s Sustainable Development Goals, which also provides a tailwind for some of these investment strategies over the long-term.
Nathan agrees, but cautions: “This is an industry that is insanely subsidised, making it largely inoperable without Government support. So, this brings up many questions about the value and quality of assets in this space.”
Returning to sector performance, Nathan says the 12-month period in 2022 following Russia’s invasion of Ukraine, when oil stocks rallied, provided advisers with a particularly powerful opportunity to discuss investment performance with clients.
“This period showcased the need for advisers to discuss stock and sector exposure with clients,” he says. “It’s important to have conversations along the lines of: ‘What happens if you are underexposed to an asset class and a country of influence and supply goes to war? Your investments might underperform.’ It’s important that clients are aware of such scenarios and the possibility their portfolio might underperform. They need to be comfortable with that.”
However, Nathan concedes that portfolio performance — whether overperformance or underperformance — is always difficult to predict and manage (for both advisers and managers) due to the uncertainty and unpredictability of markets and geopolitical conditions.
While people still care about ESG, they care more about having to pay 30 per cent more for groceries. So, responsible investing has fallen down their priority list when they think about investing. Dealing with the challenges of today’s cost of living pressures is making it harder for people to think beyond that, which includes saving for their retirement
Prepare to be different
When discussing responsible investing with clients, John Woods, CFA — Deputy Chief Investment Officer and Head of Multi Assets at Australian Ethical — believes there are a number of key advantages to this type of investing. One of these advantages is the way in which responsible investing addresses environmental, social and governance (ESG) problems. He says if investors can find ways to solve these problems, they can be rewarded well through price appreciation and earnings growth.
“But you have to be prepared to be different,” says John. “What is difficult in constructing ESG portfolios is you have to look for ways to be rewarded for the tracking error you take, like the unintentional biases that, say, a value manager has. So, you want to be very deliberate about the differences in your portfolio and ensure you’re being rewarded for them.”
As a Behavioural Finance and Economics academic from The University of Sydney, Dr Danielle Kent has had many conversations with investment professionals. While she acknowledges there is a difference in the long-term time horizon of professionals working in superannuation, compared to those who are focused on shorter-term investment horizons, she believes that when looking towards the future, both types of investment professionals had a shared orientation towards responsible and sustainable investing.
However, Nathan notes that with the current cost of living pressures, responsible investing has taken a hit with investors, as they focus more on paying for everyday living expenses, such as food and mortgages, rather than investing for social good.
“While people still care about ESG, they care more about having to pay 30 per cent more for groceries,” he says. “So, responsible investing has fallen down their priority list when they think about investing. Dealing with the challenges of today’s cost of living pressures is making it harder for people to think beyond that, which incudes saving for their retirement.”
I believe that businesses generally are thinking about their stakeholders more broadly than just their shareholders. A lot of the pressure is coming from customers and employees. So, what we’re seeing is not just a push to ESG investing but rather, it’s a fundamental societal shift and improvement in the way we think about the world we live in
A fundamental societal shift
This year’s very public decision by Woolworths to refrain from stocking Australia Day merchandise, has squarely put the focus on businesses taking a stance on specific ESG issues. Adam believes the management team of many companies are feeling increasing pressure by shareholders to be more responsive to ESG issues.
Nathan agrees the Woolworths’ decision created a lot of noise and commentary in the market, but he believes it’s more important to determine what the actual problem was and the impact of the decision being made, versus imported political outrage.
It’s a view largely supported by Tony, who also sees a move away from shareholder primacy to stakeholder primacy.
“I believe that businesses generally are thinking about their stakeholders more broadly than just their shareholders. A lot of the pressure is coming from customers and employees. So, what we’re seeing is not just a push to ESG investing but rather, it’s a fundamental societal shift and improvement in the way we think about the world we live in.”
ASIC has recently said that transparency is the best antidote to ‘greenwashing’. I believe it’s beholden on fund managers to ‘say what you’re going to do, and do what you say’. It is imperative that fund managers are able to demonstrate authenticity, which is primarily delivered through transparency
Technology and transparency
According to Nathan, the evolution of technology within the managed accounts space is allowing advisers to increasingly construct nuanced portfolios of responsible investments for their clients. He says direct investment optimisation is allowing advisers to maintain separate managed accounts for their clients.
“Twenty years ago, SMAs weren’t available for everyday ‘retail’ advisers or clients, but now there are plenty of options available. MDAs are also becoming readily available. Technology will continue to develop rapidly to meet the needs of advisers and investors,” he says.
It’s expected that technology will continue to play a pivotal role in the transparency of ESG products, particularly in terms of ‘greenwashing’.
“ASIC has recently said that transparency is the best antidote to ‘greenwashing’,” says Adam. “I believe it’s beholden on fund managers to ‘say what you’re going to do, and do what you say’. It is imperative that fund managers are able to demonstrate authenticity, which is primarily delivered through transparency. This will also make the job of the ratings agencies that much easier.”
However, he believes that investors also need to shoulder some of the responsibility of ensuring their investments align with their values and objectives. For Adam, that means looking ‘under the hood’ of investments and properly understanding the stock or fund they’re investing in, particularly in relation to exposures and the returns they’re likely to get.
While Tony agrees that product transparency needs to improve, he disagrees that ordinary investors should be expected to conduct their own research when it comes to stock selection.
“As an individual investor, I don’t have the time to look at stocks,” says Tony. “Instead, I’ll put my money in a fund and invest with a fund manager, trusting them to do what they say they’re going to do. If I had the skills to understand what’s going on inside a portfolio, then I’d do it myself. But the majority of investors don’t have the skills, instead, they outsource that work to professionals who have the expertise.
“And that’s where transparency and trust kicks in. It’s so important that investors are confident that managers actually do what they say they’re going to do, and the product they’re investing in is fit for purpose.”
About
Adam Myers is Executive Director at Pengana Capital;
Nathan Fradley is Co-Director of Ethos Impact Australia and a Senior Adviser at Tribeca Financial;
John Woods, CFA is Deputy Chief Investment Officer and Head of Multi Assets at Australian Ethical; and
Tony Adams is Head of Sustainable Investment Research at Lonsec.
They were part of a panel discussion about ‘What is on the horizon for responsible investing?’ at an IMAP Independent Thought Roundtable (in association with Pengana Capital).
The panel was moderated by Dr Danielle Kent — a Behavioural Finance and Economics academic from The University of Sydney.