By Gareth Stokes
Environmental, social and governance (ESG) factors now rank alongside risk and return as key factors when making asset allocation decisions. The fervour with which global asset managers are throwing their weight behind impact and sustainable investment opportunities is not only evidenced by the massive inflows to ESG-focused equities, exchange traded funds and unit trusts in 2020/21, but by its naked display at most investment outlook roadshows over the past year or two. It would seem that ESG is the only emerging investment theme with the legs to keep pace with technology, and whereas ESG is grounded in common sense, the technology boom is showing signs of dizziness in an atmosphere of irrationality.
Growth stocks dominated equity market returns in the immediate recovery following the March 2020 pandemic crisis, driven by investors’ hunger for exposure to firms that could generate revenue in a remote work, stay-at-home environment. The result was that the US-listed FAANGs (Facebook, Amazon, Apple, Netflix and Google) and Chinese technology darlings such as Alibaba and Tencent rewarded investors with stellar returns last year; despite having been on multi-year highs when Covid-19 first surfaced. There are strong arguments for the record high valuations placed on many of these companies, but some asset managers are concerned that technology-backed growth stocks cannot maintain this level of price exuberance indefinitely.
An Allan Gray and Orbis Investments update held in May this year revealed that US equities have never been dearer. A decade ago, the cheapest US-listed companies were trading at six times earnings and the most expensive at around 25 times; today, the cheapest firms are still stuck at six times, but the most expensive are at nearly 80 times! “We are seeing a disconnect between asset prices, on the one hand, and incomes, on the other … with the ratio of US equity market capitalisation to GDP at an all-time high,” said Jacques Plaut, a portfolio manager at Allan Gray. He observed that commodity prices and house prices were increasing way faster than incomes in the US and most other developed markets too.
Investors’ trading behaviours in crypto assets, individual shares (think Game Stop) and SPACs (special-purpose acquisition companies) were held up as examples of how uninformed investors with too much cash are driving individual shares (and even entire asset classes) deep into bubble territory. Throughout 2020 and during the first half of this year, Ms and Mr America were throwing their pandemic support cheques at trading platforms like Coinbase and Robinhood in the hope of riding the next penny stock or cryptocurrency “to the moon”.
The cryptocurrency universe expanded to almost US$2 trillion, while GameStop, an obscure and struggling share, surged from less than US$20 to US$350 in a matter of two weeks. SPACs, a US equity market phenomenon described as “blank cheque companies”, raised nearly US$200 billion from investors in 2020 and were close to exceeding this amount by mid-May 2021. “Another danger sign is that, towards the end of last year, there was so much demand from retail investors to buy stocks and options that certain global brokerages could not cope,” said Plaut.
These opening paragraphs paint the irrational return expectations that retail investors are demanding from asset managers, with scant regard for such trivialities as asset allocation strategies or portfolio benchmarks. It also explains why asset managers are under increasing pressure to expand their investable asset universe to include crypto-assets such as cryptocurrencies and non-fungible tokens (NFTs).
Most are taking a cautious approach, constructing portfolios in line with their investment mandates, appropriately matching risk and return objectives. More importantly, asset managers are starting to assess all investments, regardless of asset class, through an ESG lens. In South Africa, this ESG slant could see longer-term investor capital, most notably that in the retirement fund industry, shift away from listed companies towards opportunities in private markets (more on that later). It is worth noting that the focus on impact and sustainable investing is being driven from the ground up, by consumers.
The mortality shock of the pandemic, the growing realisation that climate change is “happening”, and renewed concerns about the impact of inequality and poverty on the global social construct have refocused ordinary consumers on the need to get maximum impact from their investments. And they in turn are pressuring asset managers, employers, financial advisers, institutional fund managers and retirement fund trustees to use their life savings to make a real difference.
ESG in practice
What does this emerging ESG focus mean and how does it play out in the investing and retirement saving environments?
In June this year, Sanlam Investments hosted a panel discussion under the banner: “Critical Conversations: The (South) Africa Investment Opportunity”. The debate centred on the role of the investment community in contributing to impactful and sustainable investing outcomes for South Africa and Africa. Andrew Johnstone, chief executive at Climate Fund Managers, suggested that the aim of investing activity had shifted from maximising dollar returns toward striking a balance between the usage and replenishment of the planet’s resources.
At the same event, Nersan Naidoo, chief executive of Sanlam Investments, noted that asset managers would always interrogate the expected financial returns from investments; the big change is that the impact of these investments is reaching parity in guiding decisions: “We have to start seeing the world through the dual lenses of financial return and positive impact.”
So, while return remains paramount, it must be considered alongside environmental and social measures, such as reduced carbon emissions, infrastructure improvements and job creation, among others. This shift is seen as crucial for the world to achieve the United Nations’ 17 Sustainable Development Goals (SDGs) by 2030. Most SDGs hinge around impactful infrastructure investment, such as renewable energy to tackle carbon emissions (climate change) or transport projects to encourage economic growth or universities to improve education outcomes etc.
Private and listed equity
Investment via private markets is seen as the only way Africa will make up the additional US$150 billion per annum in infrastructure investment needed for the continent to meet the SDGs by 2030. Johnstone noted that infrastructure was essential for economic growth as it serves as an enabler of trade; offers a safe-haven for investor funding; and remains the best tool to manage and mitigate climate change and adapt to the consequences of it. He added that it would take coordinated efforts from asset allocators, businesses and retail investors – working in concert with government – to channel capital into the right opportunities.
The private sector will play a significant role in expediting these efforts. “Businesses are influencers and decision makers in the allocation of capital,” said Andile Khumalo, chief executive of Khumalo Co, during the Critical Conversations debate. “What is the point of business if the money we allocate and decisions we make do not serve society?” The panel agreed that a mass mobilisation of capital, spearheaded by private-public partnerships, was necessary to address the continent’s infrastructure investment shortcomings, with Johnstone chipping in that blended finance was probably the best way to augment small amounts of government capital with trillions in private market funds.
The ESG debate is slightly different in the South African listed company context. Commenting during an “Investing Green” presentation in June, Nigel Green, group personal account chief executive at deVere, observed that the growing focus on ESG factors in investment decision making could see ESG replace “Baby Boomers” as the main trend driving financial market returns. “There is a massive trend towards ESG investing and it is compounding,” said Green, pointing out that fund managers had seen a 20% increase in fund flows to ESG opportunities over the last 12 months.
These fund flows have been driven by consumer choice, government incentives to produce and consume “green” goods and services, and the achievement of return parity between ESG and non-ESG funds. In the past, ESG investing resulted in a trade-off between conscience and return; nowadays investing with due concern for E, S and G factors is expected to deliver market returns or better. For asset managers, the ESG trend involves ensuring that clients can protect their capital and generate real returns, while simultaneously investing to achieve “net good” environmental and social outcomes.
ESG versus investing for impact
Is ESG an investment theme and should it be favoured for its investment merits or rather viewed as a form of capital philanthropy?
“The pursuit of delivering a world that can develop in a more sustainable way is a significant investment theme,” said John Green, chief commercial officer at Ninety One. “And there are plenty of related sub-themes, such as decarbonisation or clean energy.” He was participating in an Asset Management CEO debate on day two of The Investment Forum, held in June this year.
But Magda Wierzycka, ex-joint chief executive of Sygnia Asset Management, cautioned that asset managers should draw a firm distinction between ESG and impact. “ESG is about marketing and presenting yourself as the most investable company … that is not going to be where the returns come from,” she said. Her belief is that a positive screening for ESG factors has little impact in isolation; rather, impact comes from allocating capital to firms that have the potential to change the world in areas such as agriculture, clean energy or healthcare provision.
How can individual investors make sure that the shares in their portfolios live up to the ESG, impact and sustainability hype?
Retail investors’ preference for ESG-friendly investment strategies has prompted a mad rush among asset managers to rank or rate companies listed on the world’s major bourses and to publish ESG ratings on their fund fact sheets. The likes of BlackRock and Schroders are leading the charge by appointing teams of internal analysts to develop and manage internal ESG screening processes as well as guide portfolio managers on their ongoing interactions with company executives.
“Asset prices and portfolio risks do not yet fully reflect sustainability-related factors, [meaning that] market factors will accelerate the reallocation of capital toward issuers and assets with positive sustainability characteristics, in turn impacting valuations,” said Sophie Thurner, ESG product specialist for BlackRock’s iShares Sustainable Products. Thurner was commenting during a Glacier International investment outlook webinar in May.
Reasons for the industry’s renewed focus on environmental factors include the record damages from extreme weather events recorded in 2020, global regulation moving decisively towards a net-zero carbon emissions economy, and the downward pressure on renewable prices due to technology innovation. Asset managers are thus under pressure to provide investors with a variety of investment approaches that will resonate with the degree of sustainability investors want to achieve in their portfolios. These solutions are unquestionably easier to structure on the global stage.
Siboniso Nxumalo, portfolio manager at Old Mutual Investment Group, reflected on “ESG integration into listed equity analysis” in his presentation to The Investment Forum 2021. He pointed out that ESG ratings were important given the proportion of South Africa’s retirement funding assets that were required, by regulation, to be invested in the JSE. Before focusing on environmental and social factors, he commented that the impact of poor governance on stock market performance was well documented, starting with the Enron and WorldCom scandals in the early 2000s. Locally, we have the Steinhoff debacle, estimated to have destroyed a staggering R219 billion in shareholder value, and African Bank.
Environmental and governance failures often overlap, as evidenced by the emissions-cheating scandal that rocked global vehicle manufacturer Volkswagen in September 2015. Shares in the German company fell more than US$25 billion immediately following the news, with a striking headline lamenting “Volkswagen’s value destruct-o-meter at US$55 billion and counting”.
“You have to pay attention to ESG factors, because when ESG failures happen you actually lose money … share prices go down,” said Nxumalo. And retail investors are cottoning on to this reality.
Paul Traynor, wealth and asset management consulting lead at EY Dublin, writes: “Increasingly investors want to know that the investments and pension contributions they are making will help to sustain and build a better world, while delivering long-term capital gains.” In other words, the asset manager’s responsibility for client’s capital expands from investing purely for return to investing for sustainable wealth generation.
Integrating ESG into stock picking was among the discussion points during the Allan Gray and Orbis Investments event, which briefly considered the pros and cons of investing in British American Tobacco, which is considered to have less-than-favourable social factors due to the well-documented mortality and morbidity legacy associated with smoking. “ESG is a big part of the process,” said Duncan Artus, a portfolio manager at Allan Gray. “We have always put a lot of work into governance, because it improves underlying companies and portfolio returns, but the environmental and social factors are complex, and it can be difficult to please everyone.”
He commented that domestic asset managers faced a unique challenge due South Africa’s relatively small universe of investable stocks, only numbering around 100. Another issue is that the economy is also heavily exposed to fossil fuels and other environmentally damaging activities, such as mining. It is therefore extremely difficult to operate an exclusionary share selection process in the South African market. “If you start eliminating things, you are left with an extremely narrow pool of assets to invest in,” said Nxumalo.
Dealing in reality
Of greater concern is what might happen to the domestic economy if the investment and financing communities pull the plug on these firms overnight: the country would be left without electricity and fuel. Avoiding the likes of Eskom (in the bond market) and Sasol on the JSE could prove impossible for SA-based allocators of capital. This reality is commonplace on the African continent. “The continent is dependent on a fossil fuel-based energy system,” said Naidoo. “We cannot switch that off overnight and expect the economies to be unaffected … and still be able to achieve the economic dividend [proposed in the SDGs].” He said the way forward involved a sensible transition towards clean energy (whether that is hydro, solar or wind) and finding an optimal balance between the current energy mix and a renewable energy future.
Local asset managers will therefore have to strive for the so-called ESG trifecta of maximising returns, minimising risk and maximising impact without strictly excluding opportunities based on carbon emissions and other ESG factors. “An exclusionary strategy does not work domestically, because we still have to maximise returns … what we can do is make sure we think smartly about the risks,” he said.
Nxumalo concluded by saying that ESG was a complicated discussion that created tension between asset managers and their clients. But he also warned that ignoring ESG-related risks would lead to trouble. “Whenever these risks come to bear, not only are they on the front page of the daily news, but they have a direct impact on your investment statements and wealth.”
The reality is that all pockets of capital, including investors’ discretionary funds and retirement funds, will have to come on board for Africa to achieve the UN SDGs by 2030. “Every allocator of capital must realise that money must be deployed in a sustainable way,” said Johnstone. “There is no if/or option; we cannot choose impact or return.”
According to Khumalo, the pressure for impact investing should not be driven by asset managers in attempts to be seen as “benevolent asset allocators”, but by asset owners: the members of retirement funds. “I am investing in my retirement fund to create a comfortable retirement; but I also want to know what [asset managers] are doing about the environment, infrastructure and addressing poverty,” he said.
On the utilisation of South Africa’s retirement fund assets to achieve impact, the Critical Conversations discussion concluded that asset managers would have to refocus from delivering a financial return on investors’ money to ensuring dignified savings outcomes – which meant delivering return in addition to impact and sustainability. “The asset manager’s role is to match the objective of a dignified retirement while ensuring that the broader community benefits from upliftment,” said Naidoo. “You can invest for impact and deliver return as well.”
This article first appeared in the 3rd-quarter edition of Personal Finance quarterly magazine. The magazine is available in digital format here at R25 or R90 for a year’s subscription.
Read the December 2021 edition of our free digital magazine IOL MONEY, for the latest on ESG issues.