The importance of ethics

ESG investing—the consideration of environmental, social and governance (ESG) factors and how they impact an investment—has been gaining traction with investors over the last few years. Even as capital pours into ESG investing, data and understanding in this area remain incomplete and opaque, which is good news for investors seeking competitive market returns.

Most Cayman captives are US dollar-denominated and managed according to conservative investment mandates (ie, they primarily hold high-priced, low-yielding US dollar-denominated bonds). An ESG overlay in the equity portion of captive investments of the captive’s portfolio may complement the conservative nature of the captive’s overall investments as it will increase diversification, mitigate risk and may improve the portfolio’s risk-adjusted returns.

These are the key conclusions drawn from RBC Global Asset Management’s (GAM) October 2016 survey of ESG asset owners, wealth managers and consultants, Near-Term Uncertainty, Long-Term Opportunity: RBC Global Asset Management Responsible Investing Survey Report. The survey reveals lingering uncertainty about responsible investing’s ability to drive financial performance and mitigate portfolio risk.

It also indicates frustration with the lack of corporate ESG disclosures, and points to evolving expectations for both investing strategies and portfolio managers. As a portfolio manager who leads an investment team here in Cayman, I appreciate ESG’s importance and have incorporated this aspect into many of our client portfolios as a result.

Alpha uncertainties and data dissatisfaction

In perhaps the survey’s most surprising revelation, less than one-third (30 percent) of respondents considered ESG investing a source of alpha, despite a growing body of research concluding that various responsible-investing factors actually improve financial returns (Figure 1). A 2015 MSCI Research Insight, Can ESG Add Alpha? found that portfolios with an ESG bias outperformed a world stock index, made up of over 1,500 large-cap equities, over an eight-year period. Specific factors valued by ESG investors have also been proved to correlate with higher long-term returns.

Investors’ uncertainty about ESG as an alpha source may derive from their dissatisfaction with the amount of accessible, relevant data. Just 17 percent of survey participants were satisfied with the quality and quantity of ESG-related data companies are making available. Conversely, 43 percent of participants were somewhat or completely dissatisfied.

While multiple efforts are underway to close this information gap, the divergence between the empirical data and the marketplace perception represents an opportunity that can be exploited for enhanced returns. It points to the need for thorough fundamental analysis in ESG investment decisions, especially for investors seeking both alpha and impact in the long term. Because ESG factors are not yet fully incorporated into valuations, we believe that investors who understand how to identify and properly consider these factors will have an advantage.

From divestment to engagement

Qualitative, ESG integrated buy-and-hold investing remains a relatively new development in responsible investment, which consisted almost exclusively of negative screens deployed to weed out companies with particularly objectionable social or environmental practices a few decades ago. Today, a majority (52 percent) of responsible investors and professionals consider negative screens a niche tactic—to be used only by mission-specific investors (Figure 2).

This represents more than a change in investing style. Rather it is recognition that engagement is more powerful than divestment. Many of today’s responsible investors believe they can encourage and enact greater positive change—and increase shareholder value—by engaging with companies on ESG issues rather than by divesting. An asset manager, who is a significant shareholder, gains access to company senior management and boards of directors, developing a voice to advocate for positive change. These investors view change as a powerful driver of shareholder value.

To be sure, negative screens remain in widespread use and divestiture campaigns can still generate enormous momentum. In recent years, the fossil fuel-free movement not only captured headlines, but prompted commitments to divest totalling in the trillions of dollars, largely driven by institutional titans including the world’s largest sovereign-investment fund.

According to RBC GAM’s survey of ESG asset owners, wealth managers, and consultants, investors are taking the fossil fuel-free movement seriously (Figure 3). Only 26 percent of respondents consider fossil fuel-free to be a fad and a full 62 percent consider it a lasting investment issue. Whether this is driven by true philosophical alignment or merely reflects investors following a popular trend remains to be seen.

Risk mitigation

There is an opportunity to exploit a market that remains inefficient but this may not be the case for long. Growing realisation that ESG can drive compelling returns will draw more interest and more capital, which will drive out some or most inefficiencies.

Opportunities will be harder to come by; however, this survey portrayed an investment approach only beginning to come into its own. It’s encouraging to see so much capital pouring into ESG-related investing, even as asset owners and financial professionals alike remain broadly uncertain about those investments’ ability to provide alpha and mitigate risk (Figure 4).

The largest proportion of respondents (40 percent) do not consider ESG a risk mitigator. But, for the one out of three respondents who does see ESG as a risk mitigator, it will be crucial to ensure they engage with investment managers who share that belief. Captives who are interested in taking advantage of this approach can employ an ESG overlay to provide risk mitigation and potentially increase your risk-adjusted returns.

The value proposition inherent in ESG investing is becoming more apparent all the time. Even as data remain imperfect, investors can see and feel the impact on their portfolio values. There are examples of value that is spectacularly destroyed by companies with poor ESG standards, particularly those with high-profile scandals or environmental catastrophes.

There are reasons why captives initially choose to be domiciled in the Cayman Islands, and it has less to do with the natural beauty of our island, the preservation efforts of our shores and wildlife and what lies beneath our oceans. However, a Cayman culture that incorporates strong ESG factors keeps directors coming back year after year.

We invariably see the importance of investing in companies with an approach that is better for the environment and for society. Seeing value created by ESG investing requires commitment to an ESG approach as well as to skilled, knowledgeable analysis and long-term ownership. As ESG integration becomes more prevalent in investment, those commitments will continue to spread across the industry and asset owners will be all the better for it.

Stephen Price is vice president & portfolio manager at RBC Dominion Securities Global. He can be contacted at: stephen.price@rbc.com

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What is alpha?

Alpha is a measure of performance on a risk-adjusted basis. Alpha measures the performance of an investment against a market index, since they are often considered to represent the market’s movement as a whole. The excess return of a fund relative to the return of a market index is the fund’s alpha.