The ethical investment boom

FT, September 4, 2017

By James Kynge

When a Warren Buffett owned company bought a stake in BYD, then a little-known Chinese car company, some sceptics were withering in their condemnation of the 2008 deal.

Car and Driver, an industry magazine, commented that it was “hard to take BYD seriously” because many of its cars seemed to be copies of older Japanese models, while their performance was lacklustre. “We drive faster in our driveways,” the magazine said.

But Mr Buffett, the celebrated US investor, is now more than vindicated. The Chinese company’s focus on electric cars and climate-friendly motoring is delivering on the promise concealed in its acronym — Build Your Dreams. Its shares are trading at roughly 21 times forward earnings, or 2.5 times the ratio when Mr Buffett bought in.

The deal stands as an example of how investing in renewable technologies can pay off. Since 2008, BYD has become the world’s leading manufacturer of electric vehicles, surpassing the wildly popular Tesla, and in electric vehicle batteries overtaking Panasonic.

The BYD investment story is a small part of a much bigger trend. Investors are finding that if they are good to the planet and to people, they also end up, on average, benefiting themselves. There is mounting evidence that funds which observe environmental, social and governance (ESG) standards in their strategies tend to outperform those that don’t by a significant margin.

“It is time for ESG investing to become mainstream,” says Isabelle Mateos y Lago, global macro investment strategist at BlackRock, which manages $5.7tn in equities, fixed income, real estate and other assets worldwide. “It is no longer just something for a few tree-hugging individuals to get involved with. In the research process of every team at BlackRock, we are increasingly ensuring that they take ESG into account.”

The outperformance of ESG strategies is beyond doubt. In emerging markets, the trend is particularly pronounced: the MSCI Emerging Markets Leaders index, which includes 417 companies that score highly on ESG, has been outstripping the dominant MSCI Emerging Markets benchmark since the 2008-09 financial crisis, with the outperformance gap reaching a record in June this year.

The effect is equally pronounced on a global level. Four indices devised by FTSE Russell, a leading index provider, which select companies involved in energy efficiency, water technology and other green applications, have all garnered better returns than their benchmark, the FTSE Global All Cap Index. Separately, inflows of capital into ESG index-tracking funds on BlackRock’s iShares platform reached a record $390m in July, bringing total inflows since 2009 to $5.7bn.

The ESG phenomenon has blossomed in spite of an absence of detailed, globally-agreed definitions on what constitutes ESG standards. Indeed, the trend feels more like a freewheeling movement with index providers, investment managers, pension fund executives and others making discretionary decisions.

The rationale behind such investing is multi-faceted. It seeks to capture the opportunity represented by clean technologies, such as renewable energy — made more cost effective by mass production in China — and electric vehicles but is also designed to guard against the downsides of the green revolution, insulating portfolios against the decline of smokestack polluters.

It is also an attempt to manage risks from the increased incidence of devastating weather events including tropical storm Harvey, which hit Texas and Louisiana last week, and the flooding that has devastated parts of South Asia over the past fortnight.

From a social perspective, the aim is to weed out companies that show scant regard for workers’ welfare and return little to the communities that serve them. For governance, the goal is to filter out state-run companies that engage little with minority shareholders, businesses with opaque disclosure standards and those riven by conflicts of interest and other abuses.

“There is a necessity to protect a portfolio against downside risks and this is the number one aspiration of our clients,” says Ms Mateos y Lago. “This is about not losing a tonne of money. If you had invested in the US coal sector in June 2014, you would have lost 85 per cent by the end of 2015.”

Although ESG is still evolving as a concept, the pull it exerts over investors appears to be reaching critical mass. Rory Sullivan, head of standards and sustainable investment at FTSE Russell, which earns most of its money from non-ESG indices, says a trend towards large capital allocations into these strategies by the world’s leading funds indicates a qualitative shift. “When we write the history of this, we will see 2017 as the year in which [ESG investing] reached a tipping point,” says Mr Sullivan.

In July, Japan’s Government Pension Investment Fund (GPIF), the world’s largest with $1.3tn under management, announced that it had selected three ESG indices to track for around Y1tn ($9bn) in Japanese equity investments. Norihiro Takahashi, GPIF president, has also indicated that allocations to ESG indices may increase in the future.

In the same month, Swiss Re, one of Europe’s biggest insurers, announced plans to benchmark its entire $130bn portfolio against ESG indices. This shift from traditional benchmarks to ESG ones will involve investment into many more ESG-compliant companies. “It is more than doing good — it makes economic sense,” says Guido Fürer, the insurer’s chief investment officer.

Emily Chew, head of ESG at Manulife Asset Management, which manages $370bn in assets, sees similar trends under way. “The infrastructure is quickly being built within large asset managers to make ESG investing mainstream,” she says. “This includes policies, staffing, governance oversight and reporting on implementation.”

Estimates of the total value of funds allocated to ESG investments are beset by classification problems. But the Global Sustainable Investment Alliance, an industry body, estimated that “ESG integration” reached $10.4tn in 2016, up 38 per cent from 2014. It defined this “integration” as the explicit inclusion of ESG factors into financial analysis.

Not everyone, however, is convinced. Sceptics argue that the outperformance of ESG indices in recent years is merely a cyclical blip, born partly from the sputtering commodities supercycle and lower oil prices. If such “old economy” stocks, which are typically not included in ESG strategies, come roaring back into fashion then ESG will be exposed for the mirage it is, they say.

Others argue the lure of “green” companies has been artificially enhanced by state subsidies doled out to meet pledges under the 2015 UN Paris climate accord. If these are stripped out, critics say, the economics of renewable energy, electric vehicles and other clean tech sectors would look much more flimsy.

Even some investors who subscribe to the ESG creed express frustrations. Mr Fürer of Swiss Re, for instance, cites the lack of clear market standards, commonly accepted terminologies and guidelines as a drag on ESG’s wider acceptance. He recently called for “the private and public sector to work together for more harmonisation . . . in the ESG area”.

Critics complain that those indices that embed ESG considerations in their company selections are often skewed towards a specific theme, such as carbon footprint reduction. Such preoccupations make them niche products only, while those that select from a broader set of ESG criteria can end up filtering out so many companies that they offer too narrow a universe for investors.

But in spite of such arguments, the job of devising clear regulatory guidelines for ESG investing is gathering pace. Since the UN Principles for Responsible Investment were introduced in 2006, the number of signatories including the Vanguard Group, Fidelity Investments and many other large investors has risen from about 100 to 1,784.

In Asia, which is emerging as a key proponent, stewardship codes for ESG investing issued either by government agencies or non-official bodies have been published in Japan, South Korea, Taiwan, Hong Kong, Singapore, Malaysia and Thailand. The UK and South Africa have also promoted such codes.

“A critical accelerant of ESG adoption is regulation and soft law,” says Manulife’s Ms Chew. “While some [of these codes] are entirely voluntary and some only ask that companies comply or explain in their enforcement, the overall direction towards more active, engaged and responsible investing is clear.”

It took years before the general scepticism towards green technologies gave way to acceptance. Now such technologies are mainstream, with renewable energy, for instance, accounting for more than half of new power capacity worldwide last year. A growing number of big investors are betting that ESG will follow the same trajectory.