A lack of clarity around environmental, social and governance (ESG) approaches to investing is creating confusion and making it harder for end investors to choose an investment product that fits their objectives and values.

Investors relying on pure ESG product scores or labels risk being misled about the true sustainability of the product’s underlying investments. According to analysis conducted by Lonsec, funds that score well on a pure ESG basis do not necessarily score well based on sustainability measures that consider the specific industries and activities the fund is exposed to.

The traditional ESG approach tends to be more about process and less about outcomes. ESG fund managers tend to look at sustainability factors in terms of the risks they pose to a company’s business model. Academic research supports the assertion that companies that follow strong ESG standards are more likely to outperform those that don’t.

While ESG analysis is an important element of a fund manager’s investment approach, it can create confusion for investors looking for investment products that explicitly align with their values.

In some cases, you can end up with a portfolio that looks very similar to the broader market when it comes to exposure to things like fossil fuels, gambling, tobacco, or deforestation. For many investors, ESG integration might sound good, but in practice it will often fail to meet their expectations.

Lonsec analysis highlights gap between ESG and sustainability

Data from Lonsec show that 19% of Australian equity managers rated by Lonsec score highly for ESG awareness but score poorly for sustainability. Likewise, 18% of managers fare relatively poorly in ESG awareness, but end up performing well in terms of the sustainability of the fund’s underlying investments.

Relationship between Lonsec’s ESG and Sustainability Scores

Source: Lonsec

Lonsec’s analysis covers 159 Australian equity funds, which are scored separately based on their ESG integration and the underlying ‘goodness’ of their portfolio.

Lonsec’s ESG score is based on the policy and reporting framework of each manager, and how deeply integrated its ESG process is with their investment decision making.

In contrast, Lonsec’s Sustainability Score looks through to the fund’s underlying investments and assesses how well they align with the United Nation’s Sustainable Development Goals (SDGs), as well as how much exposure the fund has—directly and indirectly—to ten controversial industries.

Most financial advisers, if you asked them, would assume there was a strong correlation between ESG and sustainability. That there is such a significant discrepancy demonstrates that we need better communication and better tools to help investors make informed decisions about where they put their money.

ESG funds must ensure they meet investors’ expectations

If ESG funds wish to be viewed as sustainable, they need to be transparent about the composition of their portfolio and the size of their exposure to unsustainable industries.

Whether it’s a company or a managed fund, what advice clients really wants to know is: what industries and activities am I ultimately investing in and supporting? While investors care about a manager’s investment process they are often more concerned about the impact their investment has on society, the planet, and future generations.

Lonsec’s Sustainability Score helps funds become more transparent by giving end-investors the information they need to build a genuine values-based portfolio.

For fund managers who agree to have their fund scored, Lonsec provides a Sustainability Report detailing the relative success of the fund in supporting the SDGs and minimising exposure to controversial industries. Lonsec’s sustainability research assesses the exposures of individual companies across the entire supply chain, allowing individual investors to make their own decisions about how and where to invest.

Finally, Lonsec’s Sustainability Score reflects the net impact of these measures, which is peer ranked and results in a score between 1 and 5 bees.

We chose bees to represent our Sustainability Score because bees are a symbolic reminder of the importance of biodiversity in maintaining the health of the planet. When investors see 5 bees next to a fund’s name, we want them to associate that fund with the most sustainable investment outcomes in the market.

There are certainly a lot of traditional fund managers who have very good ESG processes and a solid understanding of the risks. However, if they feel the market is compensating investors sufficiently for these risks, they’ll take them. This is because they’re thinking about ESG in terms of the future value of a firm, but they’re not necessarily thinking about the future of the planet or society.

There are funds that will be assessed strongly by Lonsec as ESG managers because they do the work, understand the risks, and engage with companies. But that doesn’t mean that their portfolios will align with what investors are looking for.

Hence the need for a new way of assessing sustainability. This new approach is crucial in order to determine what is really going on behind the ‘sustainable’ and ‘ESG’ labels. This means looking beyond the marketing stories that funds are trying to tell. Instead, we need to assess portfolios based on what investors are actually exposed to: the companies, industries, and practices that make up the fund’s portfolio.

By mapping these exposures to the SDGs and controversial industries, and distilling this into a single score, we hope to give investors the tools and information they need to make investment decisions that result in the sustainable outcomes they are looking for. We also want to present this information in a way that allows users to clearly demonstrate how their investment selection is helping them contribute to a better world.

ESG is not a redundant process, but investors need to be aware of what they are and are not getting from it. If investors understand what ESG products are trying to achieve and how they work, then they may find these products valuable. If not, then they have the information they need to find more sustainable alternatives. It all starts with education and transparency.

To help advisers and their clients navigate the often confusing sustainability landscape, Lonsec introduced its Sustainability Scores to give users an understanding of how well an investment product—whether an exchange trade fund (ETF), managed account, or traditional managed fund—lives up to its sustainable credo.

Funds covered by Lonsec are issued with a Sustainability Score, which reflects the underlying investments of individual products and their compatibility with the United Nation’s 17 Sustainable Development Goals (SDGs). Ultimately, the purpose of the Sustainability Scores and the underlying research is to help investors answer the fundamental question: ‘What am I really invested in?’

If you can’t answer that, then you don’t know whether your portfolio is truly delivering sustainable outcomes.

Under Lonsec’s sustainable research approach, a Sustainability Report is issued for each fund that undergoes assessment. This is a two-page document detailing the relative success of the fund in supporting the SDGs, together with any exposure to 10 controversial industries. The Sustainability Score reflects the net impact of these measures, which is peer ranked and results in a score of between one and five bees.

There are plenty of fund managers who claim environmental, social and governance (ESG) credentials, but how many of them are the real deal?

As investors become more interested in sustainable and ESG investing, fund managers are responding with an ever-growing range of investment products.

But the challenge for advisers is in distilling the true-to-label ESG players from those which only tick some of the boxes. Unfortunately, there are information asymmetries and knowledge barriers that can get in the way.

There have always been ‘pretenders’ in the mix when it comes to ESG managers, but part of the issue is that mum and dad investors view ESG very differently to professional fund managers. Confusion partly arises due to the different approaches to ESG, and this is where a gap in understanding arises.

Often, when institutional fund managers discuss ESG, they are looking at it through an investment prism: i.e. how ESG risks affect the value of a particular company. However, when regular investors consider ESG, they are primarily concerned about the ESG risks as they pertain to the planet and their community.

The bottom line is that institutional fund managers and regular retail investors may be approaching ESG from two different angles. Part of the education process for advisers is to work through this discrepancy and ensure that what their clients are investing in genuinely meets their expectations.

In order to do this, advisers need to understand the underlying investments of individual investment products and be in a position to make assessments and comparisons based on objective criteria. This is why Lonsec has been working with advisers to develop a new suite of research that is designed to give people the ability to identify investments that align with their values.

 The Lonsec Sustainable Managed Portfolios were launched on HUB24 on 8 December 2020 and investor capital was put to work immediately in improving societal and environmental outcomes. The Sustainable portfolios have been well supported to date, with an increasing number of investors looking to invest in not only a way that delivers solid returns, but also aligns to their values.

While we don’t yet have a full month of performance to report on, the portfolios have performed in line with our expectations over the first few weeks, generating positive returns for investors.

And looking forward, there couldn’t be a better time to invest sustainably.

Momentum on climate action is gathering pace as governments, companies and communities seek to move out of this COVID-19 induced haze and look towards a greener and more equitable recovery.  Europe and the UK have committed billions towards what some are terming a ‘Green Industrial Revolution’, encouraging innovation and private investment in clean technologies, creating hundreds of thousands of jobs, while at the same time protecting the environment. China too, has backed a ‘green recovery’, setting ambitious targets for reducing carbon emissions, re-forestation and increasing renewable energy sources including wind and solar. With the US re-joining the Paris agreement on 20 January 2021, two thirds of global polluters have now committed to carbon neutrality, or net-zero emissions by 2060 at the latest. These recent developments provide strong regulatory tailwinds for those wanting to invest sustainably.

And while some governments have been dragging their heels on the climate action front (Australia is looking increasingly isolated in its stance), locally companies are forging ahead with their own commitments to reaching net zero. According to Climate Action 100+, 43% of the world’s largest emitters (including Qantas, BHP and Woodside Energy) have now adopted some form of net zero emissions target. While the nature of those targets varies, we view this as an important step and highlights the positive impact capital owners can have through direct shareholder engagement.

Shareholders are voicing their concerns on a range of ESG issues from modern slavery to gender diversity as well as climate related issues. Public awareness of sustainability issues has never been higher.  As the Boards of AMP and Rio Tinto are now acutely aware, listening to and responding to broader stakeholder concerns is becoming increasingly important.

But for all this optimism, there is still much work to do, not only on the climate front, but across a range of other Sustainable Development Goals (SDGs) to which these portfolios aim to align themselves.  COVID-19 has exacerbated inequality around the world, health outcomes have diverged significantly, and poverty is on the rise particularly in some of the hardest hit developing nations. It is important that as we move into 2021, governments, companies and investment managers alike look to maintain that positive momentum and ensure no-one gets left behind as we build back better.

Now, let’s get to work!

Portfolio update

From a portfolio perspective, one of the ways we work to align the portfolio with SDG 13: Climate Action is through our investment in BNP Paribas Environmental Equity Trust.  The strategy is managed by Impax Asset Management, a London based manager who invests globally in companies that are active in the resource efficiency and environmental markets.  The top holding in the Trust is Linde Plc, a global leader in industrial gases.  In January 2021, Linde announced it would build and operate the world’s largest PEM Electrolyzer for Green Hydrogen. Once built the total green hydrogen being produced will be able to fuel approximately six hundred fuel cell buses, driving 40 million kilometres and saving up to 40,000 tons of carbon dioxide tailpipe emissions per year. This investment also aligns well to SDG 7: Affordable and Clean Energy.

On the fixed income side, the Pendal Sustainable Australian Fixed Interest Fund invested in the Australian dollar KfW Green Bond. KfW is a development bank owned by the German government Projects supported by this bond include the construction of a wind park, solar farm and energy efficient housing in Germany. This bond aligns well to a number of SDGs including SDG 7: Affordable and Clean Energy, SDG 11: Sustainable Cities and Communities and SDG 13: Climate Action.

With initiatives such as the Net Zero Asset Managers initiative, launched in December 2020, global fund managers are also committing to net zero. This initiative aims to secure further backing among asset managers to eliminate greenhouse gas (GHG) emissions from their portfolios. Three managers we are invested with have joined as founding members of this initiative; AXA Investment Management, Wheb and Atlas Infrastructure.

From 1 January 2021, Ausbil announced that it was removing fossil fuel exposure from the investment universe for the Ausbil Active Sustainable Fund.  This includes the exploration, mining and/or distribution of fossil fuels, such as oil, gas, oil sands and coal.  70% of the equity managers in the Lonsec Sustainable portfolios now exclude all forms of fossil fuel investments, the remaining 30% exclude at least thermal coal.

Role Role
Australian Equities Real Assets
Australian Ethical Australian Shares Fund ESG / Sustainable / Impact Resolution Global Property (Hdgd) ESG
Alphinity Sustainable Share Fund ESG / Sustainable ATLAS Infrastructure Australian Feeder Fund AUD Heged ESG
Ausbil Active Sustainable Equity ESG / Sustainable VanEck Vectors Australian Property ETF Passive
BetaShares Australian Sustainability Leaders ETF ESG / Sustainable
Global Equities Fixed Income
AXA IM Sustainable Equity Fund ESG / Sustainable Pendal Sustainable Australian Fixed Interest Fund ESG / Sustainable / Impact
BNP Paribas Environmental Equity Trust ESG / Sustainable / Impact Altius Sustainable Bond Fund ESG / Sustainable / Impact
Pengana WHEB Sustainable Impact Fund ESG / Sustainable / Impact PIMCO ESG Global Bond Fund ESG / Sustainable / Impact
BetaShares Global Sustainability Leaders ETF ESG / Sustainable Vanguard International Fixed Interest Index ETF Heged Passive

Outlook

The last quarter has seen a sharp rotation into some of the more cyclical and value orientated sectors of the market. We expect this rotation to be relatively short lived. Longer term, we see the thematics that have underpinned the strong performance of the ESG/Sustainability sector over the last 18 months to remain intact.  Companies that are focused on delivering solutions to the challenges facing society and the environment are particularly well placed in a low-growth world and one boosted by a green recovery. Regulatory tailwinds and green fiscal policy initiatives are now providing good support. Companies that perform well on ESG metrics, that is companies that understand and factor in the risk of climate change, companies that are well-governed and maintain their social license to operate by meeting stakeholder expectations, should also outperform. Opportunities abound as we emerge from COVID-19 pandemic with the chance to ‘rebuild better’.

Watch the recording.

Many of you will be aware that your clients are increasingly seeking out investments that align with their personal values.

Further to the launch of the Lonsec Sustainability Score, the Lonsec Sustainable Managed Portfolios will utilise Lonsec’s extensive portfolio construction experience, together with detailed sustainable investing (and ESG) research, to provide a solution that genuinely caters to the needs of investors.

Listen to the key members of the Lonsec investment team to find out more about how the portfolios are formulated and how they can help deliver what your clients really need.

The live webinar was held on Wednesday at 10 AM AEST, 15th of July, 2020

Overview

During our past webinar “Sustainability vs ESG: What is your client looking for?”, our platform was inundated with questions from attendees.

We weren’t able to respond to everyone, so by popular demand, we decided to hold a special Q&A event, so Lonsec could respond to the questions we received about the Sustainability and ESG process. 

Financial advisers are increasingly being asked to take their clients’ environmental, social and governance (ESG) expectations and ethical considerations into account when recommending financial products. Whilst the term ESG is becoming increasingly common, the objectives of fund managers and end investors don’t always align and can be a source of great confusion.

Darrell Clark, Manager, Multi-Asset, and Tony Adams, Head of Sustainable Investment Research at Lonsec delved deeper into the topic and responded to attendees’ burning questions!

 

If you attended our live webinar, please note that further instruction on how to receive the CPD Points will be delivered to your inbox in the next 8-12 business days. Whilst we aim to ensure every attendee receives CPD Points, it is within the guidelines provided that you are required to attend the full duration of the live webinar to receive your CE accreditation. Our technology platform collects data that reflects the duration and your full engagement during the live session.

CE/CPD accreditation is provided by our CE Accreditation Partner, Portfolio Construction Forum.


The content, presentations and discussion topics covered during this event are intended for licensed financial advisers and institutional clients only and are not intended for use by retail clients. No representation, warranty or undertaking is given or made in relation to the accuracy or completeness of the information presented.
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