#SRI — 08.06.2017

You Can’t Be SRI-ous?

Prashant Bhayani

First of all what is SRI, ESG, and Impact Investing?

There is considerable confusion regarding what SRI, ESG, and impact investing encompass. One should view Sustainable Responsible Investing (SRI) investing whether via ESG (Environmental, Social, and Governance) factors or Impact Investing as an important tool to enhance one’s investment approach, full stop, when conducting analysis on a portfolio or security. This is no different than any other important investment criteria.

What is SRI?

One type of SRI is the formal inclusion of ESG factors into investment portfolios and solutions. This can take shape in many forms, like screening out certain companies due to labour practices or lines of business. Furthermore, more explicit guidelines could maximize the portfolio weighting tilted to highly-ESG-scored companies versus lowly-ESG-scored companies. Crucially, studies illustrate that companies with high ratings in ESG attributes can outperform lower ESG rated corporates in the medium to long-term2.

Corporate Governance is crucial to unlocking long-term shareholder returns. For example, does a company have anti-takeover provisions? Is the board independent? Are there related party transactions? Do they incorporate ESG factors in their business practices? Studies show again that these companies have both a lower cost of capital or risk and better returns over time.

Comparatively, impact investing is a method that actively seeks companies that make a social or environmental impact while also generating financial returns. The investors would monitor the social and environmental progress of investments as one of their key investment benchmarks.

Let me give an example of a company funded by impact investors which was listed only in 2010. Seven years ago, the global auto industry was viewed as an ultra-competitive, technologically advanced, mature industry with extremely high barriers to entry. It comprised erstwhile competitors such as Mercedes Benz, BMW, Toyota, and GM but even so, was revolutionized by a company funded by impact investors.

This company was Tesla, it didn’t view itself as an auto company rather a battery company that makes electric cars. Now its market capitalization is greater than GM or Ford. As this example illustrates, this investment style is a more dynamic approach and complements the traditional screening based ESG methodology to generate positive societal impact as well.

Explosion in Asset Growth – Follow the Money!

Source: PRI, BNP Paribas Wealth Management

This topic in Asia is still in its infancy in terms of understanding and penetration. When we look at both Europe and the US, the institutional investors, endowments, and pension funds have led the charge to sustainable investing. The growth in assets has been breathtaking globally with assets increasing exponentially (by 25.3 % CAGR) over the past ten years (Exhibit 1). For example, in Europe more than 52% ($12 trillion USD) and in the US nearly 22% ($8.7 trillion) of all investable assets are managed with either a sustainable, responsible, or impact investing style3.

In Asia, less than 1% of assets are managed with a SRI framework3. As these assets will target companies following ESG policies, the old adage “follow the money” comes to mind. What do I mean? Well, as more and more money follows these companies, there is a window of time that these companies will outperform. In Asia, where allocations are starting from a much lower base, the opportunity is even exponentially greater, in terms of market inefficiency and the alpha upside, as the weight of money follows these strategies. In short, get on board or miss the alpha train because it is soon leaving the station.

How does incorporating ESG principles into your investment allocation add returns and lower risks?

In addition to the growing inflows, there is an outperformance from adding these strategies to your investment allocation. There is a misconception that somehow you could sacrifice returns for impact. On the contrary, by incorporating Environmental, Social, and Governance factors into your general investment allocation, it will not only enhance your ability to achieve higher returns with lower risks but also the ability to control where your money makes an impact in society. These factors are not mutually exclusive but complementary. SRI companies in general are exposed to higher growth areas of the economy, generating better returns and exhibiting higher pricing power. Examples of such benefits are observed in companies producing batteries for electric cars vs. traditional petrol engines, natural gas vs. coal, organic vs. junk food, and energy saving building materials.

On the other hand, companies which do not incorporate SRI compliant policies can suffer losses, litigation, brand damage, and customer backlash. For instance, we have seen oil and nuclear companies facing potential bankruptcy or significant financial losses in the event of an accident. Investors can then lower risks by excluding these types of companies, avoiding unwarranted losses and drawdown in their portfolios.

As a result, utilizing these insights has proved to generate material additional alpha. Since 2001, the MSCI KLD 400 Social Index has outperformed mainstream markets in the US, Europe and Japan

Source: BNP Paribas Wealth Management, Bloomberg, 6 Jan 2017 - Returns are all rebased in EUR

For CEOs and CFOs: it lowers cost of debt and equity issuance

Companies directly benefit not just from an impact perspective but also who comply with environmental regulations can experience a lower their cost of borrowing. Furthermore, studies illustrate that companies with high ESG scores have a lower cost of capital, i.e. they can raise debt more cheaply, while firms in the lower half of corporate social responsibility (CSR) have almost 15% higher spreads4. This is important as this puts the decision to follow these tenets squarely in the CEO/CFO decision making process. Another reason is there is such an interest by corporates globally in following, adopting, and advancing sustainable policies. It also leads to social good and customer retention/loyalty. Basically, it is good for business.

In conclusion, there is sometimes a misunderstanding regarding SRI, ESG, and Impact Investing. Incorporating ESG factors in a best-in-class approach is a new key investment approach. These are factors which will enhance portfolio returns with the added benefit of your capital being allocated to sustainable investments. Investors who utilize these factors have outperformed by increasing return potential while also lowering risk. We have seen this as well at the corporate level where companies that employ ESG principles have the potential to raise debt at a lower cost and equity at a higher valuation. Finally, there are increasing portfolio flows to these investments and the trend will continue to accelerate, in particular, in Asia.

1) Hedgeable, https://www.hedgeable.com/impact-investing

Image vectors by Freepik, http://www.freepik.com/free-vector/green-icons-about recycling_959506.htm

2) Corporate Sustainability: First Evidence on Materiality
3) 2016: Global Sustainable Investment Revie
4) The Impact of Corporate Social Responsibility on the Cost of Bank Loans