6 myths of sustainable investing

By Larissa Fernand |  09-10-19 | 
 
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Larissa Fernand is Website Editor for Morningstar.in. She would like to hear from you and welcomes your feedback.

Sustainable investing, or ESG investing, the acronym for Environment, Social and Governance, is gradually gaining traction. The idea that Sustainable Investing is not about changing the world, it's about understanding how the world is changing resonates with investors.

Not just abroad, even in India.

In fact, the Morningstar India Sustainability Index delivers exposure to a portfolio of about 80 Indian companies that exhibit high standards of sustainability while maintaining a risk/return profile similar to that of market. The top companies include Reliance Industries, infotech majors such as Infosys, Wipro, and financial services companies such as HDFC, Kotak Mahindra, and Axis Bank.

Along with the awareness comes an entire bunch of myths. DAN LEFKOVITZ, Strategist at Morningstar Indexes, decides to bust few of them.

He presented on this subject in detail during a visit to Mumbai. I have pulled out relevant matter from his presentation and summed it up below.

Myth No. 1 – ESG is just negative screening.

ESG is being conflated with ethical investing. The latter have a list of no-go areas which are excluded from their portfolios. Some common businesses or industries would be

Alcohol, tobacco, gambling or adult entertainment.

It could be an exclusion based on human rights. Certain investors boycotted South Africa and divested from the country in the 1980s to protest against apartheid. In the early 2000s, some investors stayed away from companies doing business in the Sudan because of the Darfur genocide.

One of the oldest players in sustainable investing in the U.S. market is Pax World Funds. It was founded during the Vietnam war and was inspired by investors who wanted to stay away from weapons manufacturers.

There might even be an environmental exclusion, such as a coal company.

All this negative screening is just a part of sustainable investing. Sustainable investing has evolved to be a much more holistic and inclusive investing opportunity, much more positive screening in nature then just exclusionary.

Myth No. 2 – Sustainable investing is myopic.

Far from it. It is living in a way that meets the present needs, while not compromising the ability of future generations to meet their needs. Sustainable investing is a long-term investing approach that incorporates ESG criteria.

So along the typical income statement and balance sheet analysis, other factors come into play with regards to environment (greenhouse gas emissions, water usage, pollution mitigation), social (workforce policies, labour standards, data privacy, product safety) and governance (independence of the board, auditing, business ethics, anti-corruption policies). All these factors are integrated into the investment process and considered them along with traditional financial analysis.

Morningstar has partnered with a company called Sustainalytics, a specialist ESG researcher. The analysts look at all sorts of indicators besides policies and procedures. They also look at quantifiable metrics such as employee turnover rate, carbon footprint, and composition of the board.

Myth No. 3 – Sustainable investing is all about values.

There is definitely some truth to the fact that investors want to align their values with their portfolio. After all, the roots of sustainable investing can be found in religion. Christianity (morality and money, the prohibition on usury), Islam (Sharia law, Islamic finance) and Hinduism (Jain style of investing that might be exclusionary in nature). But today, a lot of investors incorporate ESG criteria for risk mitigation.

The CFA Institute put out a great report on sustainability a couple of years ago where they focused on this concept of materiality. Most companies that experienced major debacles that have had a huge impact to their bottom line financial distress had issues related to ESG considerations.

  • Corporate governance issues were evident in some of the banks in India.
  • BP had a horrible record when it came to health and safety. So, a lot of investors that incorporate ESG criteria did avoid BP for that reason and managed to sidestep a huge land mine - the Deepwater Horizon in the Gulf of Mexico.
  • Some sustainable funds always avoided investing in Facebook due to data privacy issues.
  • Exxon Mobil is one of the largest integrated energy companies in the world, very involved in fossil fuel related energy sources. There was a shareholder resolution, passed with 62% of the vote, asking Exxon to produce an annual report on how the company contributing to climate change and how climate change is affecting it. This same shareholder resolution had been floated for several years running but never exceeded the 50% threshold until 2017. Norwegian Sovereign Wealth Fund, California Teacher Retirement System, Vanguard, BlackRock, State Street Global Investors, are some that decided to vote in favor of this shareholder resolution. All saw climate change as a major financial risk to Exxon. How can you analyze Exxon from an investment standpoint if you don’t consider how it's business model might be impacted by climate change? A utility company that’s reliant on fossil fuels - investment analysis must consider climate change and how the transition away from fossil fuels towards lower carbon intensive energy sources might impact it.
  • Insurance companies are recognizing that the impact from climate change is going to be more eminent and more severe than previously anticipated. Huge natural disasters will be more frequent, which in turn will have major implications for the insurance industry.
  • Evaluate a company taking into account its labour standards and what it does to attract and retain top level talent. In the knowledge economy this is crucial and can give you a competitive advantage over the competition.
  • On the governance side, an independent auditor and an independent board provide important checks and balances on corporate managers. These things are material. So much of corporate value these days is in intangible assets - people, intellectual property, brand, reputation.

Myth No. 4 – Only rich countries can afford to worry about sustainability.

There is a perception that when Western developed markets were at earlier stages of development, they polluted the environment, exploited their workers, and greased the wheels with corrupt business practices. Now that they have reached certain living standards, they have the luxury of being concerned with ESG issues.

There is some truth to this, but not the complete picture. We do this report called the Sustainability Atlas. We look at the ESG profiles of countries by applying company level ratings to their country indexes. And we can evaluate sustainability by looking at how these country indexes score by company level sustainability.

  • Europe is the leader when it comes to sustainability; in fact, European companies were pioneers when it came to ESG practices.
  • Australia scores very well too.
  • Colombia is more associated with Pablo Escobar, but the companies comprising the Morningstar Colombia index actually score very highly for sustainability and Sustainalytics judges companies versus their industry peers on a global basis. So, companies like Bancolombia, Sura Insurance have adopted best practices when it comes to ESG factors relative to their global industry peers.
  • Turkey has some pretty sustainable companies.
  • Taiwan is a narrow market dominated by Taiwan Semiconductor, a global leader when it comes to semiconductor space in terms of ESG.
  • South Africa scores pretty well; Naspers, which has a huge percentage of market capitalization, has pretty good ESG practices.
  • Russia and China score poorly.
  • We applied the ESG ratings to the Morningstar India Index of about 350 companies, and India is below the global midpoint, but actually scores better than the U.S. and about the same as Brazil. Companies like Infosys, Wipro, M&M and L&T score pretty well when it comes to ESG.

Myth No. 5 - Sustainability gets a lot of talk, not assets.

According to the Global Sustainable Investment Alliance, assets in sustainable investments globally have multiplied by factor of 6 over the decade spanning 2006 to 2016. While retail is growing, it's mostly an institutional phenomenon - pension funds, sovereign wealth funds, endowments have the bulk of the sustainable assets.

The Morningstar database for retail funds globally that are intentionally sustainable shows that while the numbers are smaller there's been considerable growth there. So, about $400 billion in 2012 sustainable assets at the retail level have grown to more than $900 billion globally over the past several years. And the number of funds is steadily increasing as well. Individuals are getting conscious of climate change and gender diversity.

Myth No. 6 - Sustainable investing is a detractor to performance.

Would you have to sacrifice returns if you invest sustainably?

Based on our research and academic literature, the consensus seems to be that exclusionary screening is sort of about even with the market; the kinds of funds that exclude perform about the same as the market. And there is some evidence the companies that score well on sustainability actually slightly outperform the market.

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