On Wednesday 13 April 2016, NN Investment Partners (NNIP) held a conference dedicated to demystifying responsible investment at Cercle Munster in the Grund district of Luxembourg City.
NNIP collaborated with the European Centre for Corporate Engagement (ECCE) at Maastricht University to conduct a research project into the effect of Environmental, Social and Governance (ESG) data on investment portfolios. NNIP, which holds €4.5bn assets under management in sustainable investments, decided to join forces with the business school to address what was described as the "tall order" of debunking responsible investment. This requires being an active and engaged investor and in return brings the benefits of complying with corporate values which creating "better and more complete investors".
Jeroen Derwall, Assistant Professor and Co-Founder of the ECCE, offered an academic perspective on the topic, explaining that the ECCE has been looking into sustainble investment for around eleven years, beginning its exploration as a research institute in 2003 into the core themes of corporate governance (governance mechanisms, valuation), sustainable banking & microfinance and sustainable real estate (valuation, benchmarking property funds [GRESB]).
However, the institute has also attracted attention for its examination of responsible investing; its forms, investor types and perfomance implications. Mr. Derwall explained that the outcome of talking to people about the matter has resulted in the realisation that every person has their own concept of what constitutes responsible investing, which then shapes their idea of how it should perform.
In fact, the concept has evolved from an exclusionary process, based on value-based rather than financial decisions involving the eschewing of stocks tied to the promotion of controversies such as tobacco, alcohol, gambling, weapons & defense and which abuses human rights, through a more positive approach actively seeking ESG leaders with a strong environmental, diversity and governance policy and proven employee satisfaction, to today's main focus of full integration.
According to Jeroen Derwall, if an investor wishes to be more alpha-focused (ie the excess returns of a fund relative to the return of a benchmark index), they should focus more on positive rather than negative "screening". The dominant academic view in finance is that RI is about investing rooted in 'norms' and values', about doing 'good' rather than doing 'well'. The ECCE has been trying to debunk that view and show that others can do well as well and show that both views on RI can co-exist in practice, what matters more is the form of RI. So-called 'sin stocks' were thought to offer higher expected return thanks to cheaper prices due to being shunned, although it has been determined that the impact these stocks usually have on investment portfolio are not all that significant.
Choosing RI can make an individual become a better financial investor because they consequently take note of important factors that may be overlooked in standard financial information. A lot of ESG you can not find in the balance sheets. These aspects can have impact on how the business will do in the future. If these two kinds of information are integrated, it creates a more informed view.
However, when selecting portfolios for their top ranking in ESG criteria, there are certain caveats to take into account: as RI grows, the market might learn more about it and little-known funds may be more highly-sought, indicatong that an individual would have to get the leatest ESG information integrated into their portfolio. It is perhaps less important to look not at what other studies have been doing, ie the level of ESG company, but the change from the year before. Biuying stocks with higher levels of ESG is better than just buying stocks with high levels of ESG.
For the collaborative study, information was obtained from two rating providers each focusing on particular aspects. It differed from earlier work, looking at international portfolios based on ESG information for over 3,000 stocks, taking into account the ESG rating tilt for the size of company (some large ones score better because they are more vocal about it).
The researchers first did what other studies had, using the rating from the rating agency to categorise stocks by putting the bottom 10% in the bottom rated portfolio, top 10% in top. Interestingly, it was determined that a portfolio with high ESG does not necessarily perform better than one with low ESG. This worked in the past but no longer does, with it instead being those that made major improvements on ESG that showed substantial performance increase compared to low-ranked counterparts. Firms that had originally low ESG, financially did better than those showing the least performance improvement.
The 'old school' approach of boycotting sin sectors may not be the way to go for returns-focused investors, although Jeroen Derwall explained how this is the case for now but by no means a static conclusion, as we are operating in a competitive environment and must be active managers.
Hendrik-Jan Boer, who is Head of Sustainable Equity Investing at NN Investment Partners and has been with company since 1998, offered a non-academic take on the topic.
Explaining the material impact of ESG factors on performance, Hendrik-Jan Boer refuted the claim that one should buy stocks when they undergo a major controversy such as an oil spill because they will sell cheap and then recover, explaining that the biggest controversies mean that it is embedded in the structure of companies such as BP, Exxon Mobile and Royal Dutch Shell and how they are governed, and therefore not something from which a business can easily escape.
It is necessary to look at all factors, how important intangibles are, related and reflected in stakeholder relations, as all will have an impact on profitability and profile. Intangible assets are becoming more and more important, as evidenced by how Apple has determined its value by how it is perceived by its clients. Apple products are seen as a luxury item and the brand promotes itself as ahead of its competitors. When Chinese supplier Foxconn, which manufactures for Apple, drew media attention for high levels of employee suicides, Apple worked quickly to set up boards to find out what the problem was, which improved the relationship with stakeholders. According to Mr. Boer, it is important to look at financial ratios, but it is not enough, you should look further. These intangibles give a company opportunity to improve its profitability and margins.
NN IP's approach to ESG Integration comprises four different angles: active ownership in terms of voting an engagement, knowing all the specifics of an individual company; integrating ESG factors in their bottom-up investment process, it is compulsory as an equity analyst to take into account all these ESG; Defence Policy, exclusions, societal values and criteria; specialised SRI strategies and tailor-made RI solutions. NNIP believe you need a holistic view and knowledge, with ESG focused on materiality and corporate bottom-line.
Hendrik-Jan Boer explained that a very important factor is portfolio construction, which should show consistency, discipline and have an open mind to all factors. He gave the example of BP, whose first major controversy was related to health and safety, leading the company to promise improvements and investments in H&S. Then second controversy came along, showing that BP promised but did not deliver. The third controvery, the Texas refining incident, created an enormous dent on the company's profile and it still has the problem of living up to new positive expectations.
High-scoring companies getting into these controversies are maybe not the best way forward. Perhaps the best are the ones that score average, but where there is an underlying positive momentum on ESG performance as they are willing to show positive change. However, still doing full checks is just as necessary as it has ever been. This is an additional aspect to take into consideration.
So what are the 'Do's and Don'ts' of RI? According to Hendrik-Jan Boer, the lesson to draw is that it is about momentum, with change having the most impact. Major exclusions seriously alter risk-reutrn metrics and simple ESG overlay is not a good plan, as it is full of many unintended portfolio characteristics. Governance impact is universal, E&S impact more diffuse. There are opportunities in combining ESG level and delta scores. Successful ESG Integration is focused on materiality, which links corporate and financial processes and links perception with reality. According to NN Investment Partners and the ECCE, this is the way going forward in sustainable investment.
Photos by Sarah Graham
