ESG investing: A self-fulfilling prophecy?

‍As South Africans, we are no strangers to environmental, social and governance (ESG) issues. In recent years, we have witnessed the damaging effect of the Cape Town drought, the social impact of countless mining accidents and a number of corporate governance scandals that are destroying our international reputation for effective governance. Investors are increasingly realising that they have been bearing more risk than they would have liked and are now demanding better disclosure and mitigation of such risks.

Increased investor interest

‍This is taking the form of greater investor focus on ESG investing, an investment approach that is about going beyond traditional financial metrics to provide a more holistic picture of an investment’s long-term prospects. It is about ensuring that an investment is being managed and operated in a responsible and sustainable manner, particularly regarding its impact on the physical and social environment with which it interacts. It is not a new topic; ESG investing has been around in various forms since the 18th century and is even considered a contributing factor to the end of apartheid. International investors’ avoidance of, and disinvestment from, South African firms in response to the country’s social injustices is widely credited as assisting in the downfall of the regime because of the toll this withdrawal of economic support took on the financial sector.

In more recent years, there has been a renewed push by asset allocators and owners to take these factors into account in their decision-making and the approach has become more formally integrated into modern day markets. Quite possibly, the rise of social media has made people more aware of the consequences of humans’ impact on the earth, the social adversity facing so much of the world’s population and the prevalence of corporate governance failures. Whatever the reason, the investment industry is undergoing meaningful disruption as a result of investors’ and regulators’ increasing demands to promote responsible corporate and investment behaviour.

This is certainly the case in South Africa and there are a number of asset managers, including the RMI Investment Managers’ affiliate boutique managers, that incorporate ESG frameworks into their investment decision-making processes.

Affiliates’ approaches

At Sentio Capital Management, ESG investing has been an inherent part of the company’s investment process since it opened its doors in 2007.

We believe in investing for good, in two senses of the phrase”, says Mohamed Mayet, CEO and co-founder. “We invest for good (as in for the long-term) but also by doing good; by being good corporate citizens and investing responsibly and sustainably. ESG lies at the core of our company analysis and has always informed our investment decisions. It is in our DNA.

Northstar Asset Management also formally incorporates sustainability factors into both its bottom-up analysis and allocation process. For Rory Spangenberg, director of global equities, this approach is crucial for growing and protecting the value of Northstar’s clients’ savings. “There are numerous studies which support the concept that companies with strong corporate cultures, value systems, governance structures and respect for their physical and social environment tend to outperform over time”. This view, together with the increased attention clients and prospective clients were giving ESG, resulted in the firm’s official inclusion of these factors into its investment processes. It is a similar story for fixed income managers, Granate Asset Management. “We genuinely believe that ESG factors are directly linked to company fundamentals”, says fixed interest portfolio manager, Bronwyn Blood. “There has been enough evidence recently that ESG issues – especially governance factors – directly impact companies’ financials, share prices and creditworthiness”. She adds that Granate is also seeing increased investor attention on the firm’s approach to ESG. “Our investors’ interrogation and questioning around ESG issues are increasing which we welcome because it shows that ESG ‘compliance’ is now being taken more seriously and not just going through the motions”, she says. “They want to know how, why and to what extent we are incorporating ESG issues into our investment process”.

Listed property investors are paying more attention to the issue too, according to Sesfikile Capital, a listed property investment manager, which also actively takes ESG factors into account. “We see genuine long-term merit in ESG investing and recognise that ESG factors play an important role in assessing the long-term sustainability of investments”, says Head of Research Naeem Tilly. “Accordingly, we believe that the integration of ESG factors into our investment process is a crucial step and will ultimately lead to increased value and lower risk for client portfolios”.

ESG still secondary for many managers

‍Unfortunately, not all South African asset managers have yet committed to incorporating ESG principles into their investment processes. The concept is still in relative infancy even though we are considered a leader compared to our emerging market peers. The Johannesburg Stock Exchange (JSE) was the first emerging market stock exchange to launch a socially responsible investment (SRI) index in 2004, the Pension Funds Act has required pension funds to “consider factors…of an environmental, social and governance character” since 2011 and the Code for Responsible Investing in South Africa (CRISA) has been in effect since 2011. Despite these helpful frameworks, implementation across the asset management industry is inconsistent and not always taken as seriously as it should be.

While the larger multi-national managers tend to publicly report on their ESG progress, and there is growing interest from smaller managers, this may still be more of a reluctant undertaking rather than a genuine one, according to Spangenberg. “Only a handful of South African managers are adopting CRISA or signing up to the UN’s Principles for Responsible Investment (PRI), the global standard for responsible investing”, he says. “Awareness is growing, however, and with more pressure on companies to report on their sustainability in greater detail, we should be able to catch up to our global peers”.

Mayet believes we are not all that far behind certain countries. ESG investing in the US, for example, is at a similar level of development compared to South Africa, but in Europe, it is more advanced and tactically taken into account on a broader basis. He believes most South African equity managers consider ESG a painful side issue that has to be dealt with rather than integrated into the decision-making process.

“In general, most equity managers broadly understand what ESG is about but there is a tendency to treat it as a box-ticking exercise”, he says. “For many, the problem is that they simply don’t know how to incorporate such factors into the investment decision and so ESG is often sidelined in favour of other priorities, such as more traditional, quantitative financial metrics”.

Blood strikes a similar tone. “Too many asset managers are focused on returns at the expense of other considerations”, she says. “There are many managers that still invest in “cheap” equity or bonds, even if there are glaring issues with environmental sustainability, social impact or governance. Many low-ESG-scoring companies still enjoy strong demand at credit auctions despite obvious ESG concerns”.

In the real estate market, the number of companies with adequate disclosure and policies relating to ESG are few and far between according to Tilly, although there are one or two standout real estate investment trusts (REITs) that do particularly well on this front.

“Incorporation of ESG factors into the investment process has gathered momentum in the asset management industry”, says Tilly. “However, the focus continues to be on governance rather than on environmental and social aspects. Managers should be doing more to materially improve disclosure on these two issues in particular”.

The E, S and G are all equally important

‍Given South Africa’s recent spate of corporate governance failures, it is perhaps not surprising that governance is the factor that most investors seem to be focusing on and asking the right questions about.

Mayet says, “Governance has certainly become more of an issue in the wake of Steinhoff, EOH and Resilient. Investors and managers are becoming increasingly aware that one needs to look beyond the numbers to assess the risks that poorly run or mismanaged companies pose to their investments”.

There is a risk though that investors are glossing over the importance of environmental and social aspects because these factors are less understood and appreciated. Mayet cites the shooting of 100 (and death of 34) striking Lonmin miners in Marikana in August 2012 as a significant social event that had repercussions across the country. Many investors had ignored the warning signs of brewing social tension and unrest leading up to the event. A proper assessment of ESG factors during the investment decision would have revealed the red flags and helped such investors avoid the stock bomb that this turned out to be.

From a real estate perspective, Tilly believes REITs can be doing much more to support the physical and social environment. “We believe REITs should spend more on community upliftment projects, environmentally-friendly practices and promoting previously disadvantaged individuals to managerial or senior positions”, he says.

Engagement rather than avoidance

‍Part of the problem that asset managers face is that misconceptions still plague the field. For example, the idea that ESG investing is about avoiding certain industries altogether, at the expense of diversification and therefore returns, is still prevalent. Mayet points out that ESG investing is more about how to encourage positive behaviour that leads to long-term sustainable returns, rather than restricting the opportunity set (which is already relatively small in South Africa compared to international markets). For example, Sasol is our biggest polluter, but it is also a strategic asset in South Africa. “ESG investing is not about shunning companies like Sasol, but rather about engaging with them to improve corporate behaviour and help them implement mitigating or compensatory measures”, he says.

On the topic of engagement, this is an area Spangenberg believes investors should be more involved in. “In South Africa where management teams are more accessible, shareholders should be taking more of an active approach to engaging with both management and each other on how to manage and implement ESG issues”, he says.

Not only should shareholders be engaging with management, but management should be engaging with rating agencies, according to Tilly. “Where possible, REITs should be working with ESG rating agencies to evaluate and improve policies”, he says. “This could help improve benchmarking across the industry too”.

More research required

‍Blood would like to see more ESG funds launched, better ESG reporting and more research undertaken on the subject.

“We would like to see more funds with distinct ESG targets being introduced to the market as well as the implementation by industry bodies of standardised reporting across investments and across funds”, she says. “Managers should also attend more forums and conduct more research into ESG investing in order to continuously improve their processes”.

A lack of research on the topic, particularly from the sell-side, appears common across asset classes. In the fixed-income world, Blood believes that much more can be done. “In general, we are not seeing sell-side reports incorporate ESG issues; they are still focused primarily on financial metrics”, she says. “Even where we do see reports that contain ESG information, coverage is light. ESG issues are also not being discussed in meetings with sell-side analysts”.

In terms of equities and real estate, it seems there has been slightly more progress in terms of ESG research although it is still an underdeveloped area.

Tilly points out that the sell-side tend to cover governance but overlook the environmental and social aspects. “Issues of governance are often raised by the sell-side”, he says. “But research relating to the environmental and social factors is lacking”.

Mayet adds, “While there is some growth in the provision of ESG research, there is still not enough coming from the sell-side. Sell-side analysts do not seem to have a great deal of detailed knowledge and information on the topic and don’t seem to possess a fundamental cultural understanding of what ESG is really about”. There is one source of sell-side research that Sentio Capital Management uses, which is streaks ahead of peers, but other than that, there is very little reliable and insightful equity research being generated.

Spangenberg agrees. “There is an increasing capability from the sell-side; however, most are lacking in the research of ESG factors”, he says.

“There are also service providers who assist with research and advice on corporate actions, in addition to data service providers such as Reuters, although this comes at a cost which smaller managers may find difficult to afford”. If you want something done right, do it yourself In Spangenberg’s view, equity managers should not depend too heavily on the sell-side and rather undertake their own ESG research. “We feel that most research has to be proprietary, especially if taken on a company-by-company basis”, he says.

This rings true for Mayet too. “As investors, we need to be asking companies the right questions ourselves”, he says. For example, before investing in a mining company, investors should be asking how the firm is rehabilitating the environment or what it is doing to protect neighbouring communities from potential health hazards like acid rain as a result of its operations. “Management will say it does this and that, but we cannot always take such assertions at face value. It is about digging deeper with your own analysis to assess whether the company is genuinely in the business of operating in a responsible and sustainable manner or not”, he says.

More needs to be done

‍There is clearly much room for improvement in the South African context. A lack of understanding of the potential long-term benefits, as well as a dearth of proper third-party research and systems, undermines further progress while inconsistent definitions and application only compound the problem.

That said, progress is being made, even if it is somewhat slow at times. Rising investor awareness, together with increased regulatory guidance, should provide a much-needed prompt to the industry to develop ESG implementation across asset classes. Managers such as Northstar, Granate, Sentio and Sesfikile are valuable examples of how to do so, and their commitment to the field bodes well for the future of ESG investing in South Africa.