Responsible Investment: Friend or fad?
14 Nov 2018 - Estimated reading time: 7 minutes
Responsible Investment is a topic that’s been creeping up the agenda of many investors over the past few years. The increased focus on this topic may be attributed to greater attention from regulators and the government as well as the media shining a spotlight on corporate governance failings and environmental concerns.
Some remain concerned that “Responsible Investment” is another fad or fashion which will soon be replaced by the next ‘trendy’ market innovation. We can understand this concern.
This phenomenon of following fads or fashions stretches back to at least the 1600’s where, during ‘Tulip Mania’, flower bulbs were the investment of the day – until they weren’t. In more recent times, Dot-com bubble investors fell for the fad and Bitcoin investors have been touted as being next in line.
So is Responsible Investment just another fad? Are we expecting investors – driven by the influence of a changing demographic – to ‘do good’ through their investment choices, with the financial implications of these choices taking more of a back seat?
This question gets to the heart of the most common misconception about Responsible Investment and the answer is unequivocally no.
Responsible Investment should no longer be viewed as a passing fashion or fad; instead it should be viewed simply as investment done properly – a mainstream feature of investing.
Responsible Investment vs. Ethical Investment
The concept of ‘doing good’ – or doing less harm, at the very least – is, for certain investors, often labelled as Ethical Investment. The investible universe of an ethical investor is refined or restricted to reflect his/her individual values or morals, for example:
- Worried about damage to sea life from potential oil spills? Avoid off-shore oil investments.
- Concerned about the health implications of smoking? Divest from tobacco.
- Appalled by human rights violations in the fashion industry? Avoid sweatshop manufacturers.
For a responsible investor, doing good is not always in his/her remit and individual values or morals are not necessarily part of investment decision-making. A responsible investor may arrive at the same decisions as an ethical investor, but the path by which they arrive at those decisions can look very different, for example:
- Oil investments may still be avoided, but other concerns relating to long-term sustainability given the continued investment of capital in resources that cannot be exploited.
- Manufacturers making use of sweatshops may be shunned, but to avoid the damage to returns arising from long-term reputational damage and potential legal ramifications.
Morality does not come into the equation for a responsible investor. He/she may adopt positions which are in direct contravention to those of an ethical investor. Take tobacco, for example. Ethical? No. Responsible? Maybe.
Ethical Investment is for certain investors. Responsible Investment is for all investors and is ultimately about the protection of long term capital value.
So what does it mean to be a responsible investor?
Assume the iceberg shown below represents the universe of information available on a company or investment.
Above the surface, we have all the financial information. Investors will search here for answers to typical investment questions; Is the dividend high and sustainable? What is the expected return on equity? Is the company generating strong cashflow?
Responsible investors (like all good Titanic fans) know that there is much more to the iceberg than meets the eye. Underneath the surface we have a host of additional information, including Environmental, Social and Governance (ESG) data on the company. This includes information that is not always widely reported or easily quantifiable, and in some cases may only be available from meetings with management.
Understanding and analysing the information hidden beneath the surface is crucial to the long-term sustainability of an investment.
Short-term investors may be lucky and avoid losses due to governance failures or social misconduct. The same cannot be said for long-term buy-and-hold investors, such as life insurers. Will the diesel car manufacturer or the ill-incentivised board really survive the 20+ year life of an annuity book?
Responsible investors recognise that value and risks may not be wholly priced into markets, and that sometimes the reasons for this may be because of ESG factors.
The assessment of the bottom of the iceberg is not about fads or fashion, it’s about identifying factors which may affect the long-term viability of, or value derived from, an investment decision.
And our survey said ….
We had the pleasure of discussing Responsible Investment at our annual Life & Financial Services seminar on 3 October 2018, and we took this opportunity to run a snap poll on the risks of greatest concern to the audience.
(Click the image to enlarge)
The results from our poll, which had 106 responses, shows that exactly half of the respondents considered economic risks to be their main priority, but only a handful felt that environmental risks were the greatest concern.
This low priority stands in stark contrast to the views of the World Economic Forum. According to their latest Global Risks Report, 8 of the 10 most pressing risks we face are climate-related, ranging from extreme weather and natural disasters to ecosystem collapse.1
In some respects, the results of the poll are not surprising. The economic risks we face as investors are well understood; they are more immediate, more measurable and more familiar to us. However firms are only just starting to get to grips with how environmental risks can be factored into the investment decision-making process.
Climate change – one part of a Responsible Investment agenda
An important example of environmental and societal risk is climate change – which is receiving ever-increasing attention from regulators, investors and the media. The potential financial implications of climate change are significant, and it presents both risks and opportunities for investors.
Recognising this, the PRA weighed in on the subject with their latest Consultation Paper (CP23/18) published on 15 October 20182. “Few firms”, they say, are taking appropriate actions against the long-term financial risks of climate change. We expect further regulation to ensure policy commitments are achieved. This will increasingly place the consideration of climate risk, and other ESG risks, directly in the path of long term investors.
Whether these financial risks crystallise directly (through damage to physical assets) or indirectly (as the result of shifting legislation and public opinion), the impacts are expected to be wide-reaching, whilst still largely unpredictable.
It’s important to recognise, however, that climate change represents only one element of a broader Responsible Investment agenda.
So what next?
To start your Responsible Investment journey there are some practical steps you can take now:
- Training and education: Understand how Responsible Investment influences investment decision-making, and how ESG factors (including climate change) affect investment risk and return.
- Formulate a set of investment beliefs: Ensure they are representative of the entire organisation by inviting debate and discussion before settling on a firm statement.
- Evaluate whether these beliefs run true through your investment strategies and related disclosures. Check that you are practicing what you preach, and put plans in place to address any shortfalls.
- Challenge your asset managers: Understand the extent to which Responsible Investment is embedded in their portfolio construction process and how this aligns with your beliefs.
Responsible Investment is certainly not a fad. It’s a topic that’s gained significant traction in recent years, and for most firms the journey is only really just beginning.
Have you thought about how Environmental, Social and Governance considerations factor into your firm’s Investment Strategy? The Responsible Investment team at Hymans Robertson would be delighted to discuss this with you further. If you are interested in having a conversation, please contact a member of the Life & Financial Services team.