Asset managers running environmental, social and governance (ESG) strategies have always contended with skeptics who argue that creating impact requires a sacrifice of returns.
Now they’re punching back.
According to presenters at the sixth annual Impact/SRI & ESG Investing track at Financial Advisor's Inside Alternatives conference in Denver, ESG strategies can produce multiple opportunities to mitigate risk, generate enhanced returns and produce impact.
“It’s an elevation of our game,” said Robert Smith, president and chief investment officer of Sage Advisory. “We’re not constrained by this in any way, shape or form. We want to be informed and engaged, we want to be enlightened investors, and we believe ESG analysis does this. This is just good business.”
In Monday’s “Segregations” discussion, leaders from three leading ESG firms explained how they’re creating both financial and ESG returns for their clients.
Wielding The Big Stick
“The mission of Parnassus Investments is to build wealth responsibly for long-term investors,” said Benjamin Allen, Parnassus’s president. “The way we’ve been able to do this is to balance principles and performance.”
The firm is an impact investing success story. Founded in a basement in 1984 as a fledgling value manager, Parnassus now manages approximately $26 billion, mostly U.S. equities, in ESG mutual funds and managed accounts. Its flagship Parnassus fund (PARNX), which was up 10.8 percent for the year as of October 24, applies a qualitative ESG screen to a value strategy.
The flagship strategy has retained a large stake in Wells Fargo, taking on a role as impact investor as the financial behemoth deals with a scandal over the creation of falsified accounts. Allen noted that Wells Fargo has consistently been a leader in encouraging diversity, philanthropic engagement and environmental responsibility.
“It was an opportunity to make lemonade out of lemons,” said Allen of the Wells Fargo holding. Parnassus’s immediate response to a corporate scandal, he said, is to gather information and engage the troubled company, working as an investor to hold it accountable.
Not every company survives the information gathering process.
“Equifax was another company we used to own; we divested after that scandal hit,” said Allen, referring to a major cybersecurity breach at the firm. “We didn’t think there were enough redeeming qualities left in the company.”
Parnassus has meanwhile proactively engaged with companies such as Disney to discuss ESG topics.
“It helps to have a big stick,” said Allen. “If you don’t have a big stick, I suggest you use carrots.”
Companies are pressured by non-governmental organizations and public campaigns all the time, said Allen, giving impact investors an opportunity to consult and offer their expertise. For example, Parnassus has helped its portfolio companies understand requests for transparency on environmental performance and sustainability. (As You Sow, a non-profit firm working in areas of investor advocacy and corporate responsibility, is a company that makes such requests.)
Beyond its flagship fund, Parnassus has a second popular strategy, its Endeavor Fund (PARWX), which is up 13.9 percent year to date. Endeavor overweights companies that score highly on workplace factors such as employee satisfaction, labor relations and safety.
“We integrate ESG research in house, and they’re combined into our mission,” said Allen. He said the ESG lens is used on companies to understand and dampen their risk.
It Pays To Be The Good Guy
Appleseed Capital is a value manager built around a separate account business for Chicago-area families. In 2006, the firm launched a go-anywhere value-oriented, socially responsible mutual fund, the Appleseed Fund (APPLX), which was up 10.3 percent for the year as of October 24. It screens out alcohol, tobacco, firearms, gambling and pornography—anything that its investors might find morally offensive.
“The SRI aspect started as part of our mutual fund, but it now goes across our business and is part of our investment process,” said Matt Blume, director of ESG research and shareholder advocacy at Appleseed.
That process has evolved so that it is now less influenced by moral factors and is now influenced more by risk management, said Blume. Appleseed now screens out all fossil fuel companies, as well as systematically important financial institutions, not merely because their investors might find them objectionable, but because ESG screens favor lower-risk companies that should, over time, enhance returns.
“Then we asked ourselves, why stop with negative screening?” Blume said. “If we believe that screening out companies will reduce risk and enhance returns, then logically, wouldn’t short-selling some of those companies we screened out earlier also increase returns and reduce risk?”
In 2014, Appleseed launched a global long-short ESG strategy available in separate accounts and via a private fund. Like many long-short strategies, its short strategy involved finding companies with attributes like weak balance sheets, high valuations and high insider selling, but Appleseed goes one step further.
“We don’t think those normal things are sufficient for actually shorting a company,” Blume said. “There needs to be some catalyst to drive shares down. We started looking for ESG miscreants: bad ESG performance with high valuations.” The firm looks at three kinds of problematic practices—those that are unethical, unsustainable or unsafe.
The firm’s short candidates are companies with high regulatory risks that engage in self-serving behavior and suffer from poor corporate governance, all characteristics that Blume referred to as “value destructive.” Valeant, the pharmaceutical firm once headed by Martin Shkreli, was among Appleseed’s short calls because of its governance and self-serving behavior, Blume said. Corecivic, the nation’s largest prison provider, was another short call because of the unsustainability of the private prison industry.
Extolling The Wisdom Of ESG Fixed Income Strategies
Sage Advisory, which has $10 billion in assets under management, held in 2,000 client accounts, has run socially responsible fixed-income strategies for 15 years, making it an early player in a still miniscule fixed-income ESG market. While the firm’s security selection process has always included a social responsibility and corporate governance screen across all of its strategies, Sage now offers ESG in taxable and tax-sensitive fixed income, as well as global equities, to its clients via separate accounts.
Smith notes that out of 1,650 fixed-income funds with over $3.6 trillion in assets, there are only 42 socially responsible fixed-income funds, or 2.5 percent of the total, representing just $17 billion, a mere half of a percent, in assets.
“There’s a lot of potential,” said Smith. “The numbers are way on the short side, but we believe that debt is where you can have the greatest potential impact and the best chance to outperform.”
In partnership with Sustainalytics, one of the largest ESG ratings firms, Sage introduced one of the first ESG optimized core investment-grade fixed-income indexes. The index matches the sector allocation of a conventional benchmark, but only includes securities issued by companies with ESG scores in the 87th percentile or higher.
Analysis conducted by Barclays has shown that an optimized intermediate-term fixed-income portfolio using such a screen can provide 40 to 50 basis points of excess annual returns, said Smith.
“That’s a world of difference in terms of outcome. If you’re looking for an asset class where you can demonstrate outperformance with zero additional risk, this is the asset class that can get it done.”
He said that ESG implementation acts as a qualitative screen. Sage uses a four-step process to implement ESG: identify organizations that are consciously and actively building sustainable business models; identify financially relevant ESG factors such as emissions, human capital, safety or supply chain issues; incorporate ESG data to enhance risk analysis and to establish a fundamental measurement of an organization moving forward; and then use ESG to help identify emerging business risks and opportunities for companies and investors over the long term.
“ESG analysis is not a quick fix,” said Smith. “It is a long-term process, and it should be viewed in that light.
“As a credit manager, we’re geared in that direction. You want to bring ESG into risk analysis.”