How ESG impacts financial advice practices
South Africa’s independent financial advisers (IFAs) must stay informed of emerging environmental, social and governance (ESG) investment trends, or risk alienating an important client demographic. “The interest from millennial investors has helped drive the rapid growth in global ESG investment, with a recent survey by the Bank of America offering a conservative estimate of USD20 trillion of asset growth in US-domiciled ESG funds between 2018 and 2038,” noted Theesan Moodley, General Manager at Sanlam Connect, during the brand’s recent Financial Confidence webinar.
What are you practising?
The webinar, titled ‘Practice makes perfect; what are you practising?’ set out to give IFAs insight into how asset managers were approaching ESG in their portfolio construction processes, among other topics. Moodley set the scene for the webinar by paraphrasing from Victor Verberk’s opening address to the 2022 Top 1000 Funds Conference. “Change has always been a feature of investments; but we are currently in the process of a deep shift in how the industry operates,” said Verberk, who is CIO Fixed Income & Sustainability at Dutch-based asset manager Robeco. “Although sustainable investing is not new, this phenomenon is developing rapidly and is being embedded across the entire industry, and globally”.
The result, according to Verberk, is that “a growing number of investors and asset owners now have a strong focus on critical topics such as climate, biodiversity and human rights as they seek risk adjusted returns, and at the same time contribute to an improved wellbeing in society”. The strong focus on impact and sustainability that has dominated asset manager discussion over the past three to five years seems to have sharpened during the 2020-21 COVID-19 pandemic. With the introduction handled, Moodley handed over to Vivek Paul, Senior Portfolio Strategist for the Portfolio Research Group within the Blackrock Investment Institute (BII), to inform the assembled IFAs about the world’s largest asset managers’ approach to sustainability in portfolio construction.
You cannot ignore the climate transition
Paul was quick to point out that his title did not include the word sustainability. However, he immediately conceded that “asset managers could no more ignore matters around climate transition than they could ignore factors around interest rates or inflation when building portfolios: sustainability is that fundamental”. It turns out that positioning for net-zero and the climate transition is among the three trends or investment themes that Blackrock believes are driving global financial market outcomes presently. “This theme is so important, so fundamental, that even in an environment where we have seen an enormous sell off in markets, [a period during which] we have seen a war in Europe and incredible inflation, we still believe that positioning for net-zero is a central theme for building portfolios today,” Paul said.
There were three key statements made during the 20-minute-long ‘sustainability in portfolio construction’ lesson, starting with: climate action is a positive for global growth. According to Paul, this view was received with some scepticism when it first surfaced, some two years ago. The reason is that analysts were comparing growth and returns on portfolios optimised for climate transition versus benchmarks that were structured as if climate change was a non-event. “The true benchmark is not one in which we ignore climate change occurring; climate change is occurring whether or not the world does something about it,” he said, before introducing the second key statement that he felt was fundamental to how BlackRock positions its portfolios, namely that the sustainable investing wave has a long way to go. More importantly, all else being equal, “leaning into the climate transition, leaning into securities that effectively will benefit from the climate transition, is a return enhancer”. The third and final point was that the climate transition represents a historic investment opportunity.
Getting the strategic asset allocation right
“There are many ways in which we can advise our clients to include certain products in their portfolios; but what we have done ‘less well at’ as an industry, is to think about how our strategic asset allocation ‘models’ the shift towards sustainability,” said Paul. In other words, financial advisers have done well at tweaking their client’s equity exposures to be slightly ‘greener’ but have failed in figuring out the optimal strategic mix of bonds, cash, equities and private market opportunities. According to Paul, the challenge facing asset managers today is to balance the sustainability risks between these asset classes.
At this point, the discussion became a touch more technical, with Paul trying to explain the climate transition in the context of macroeconomics, repricing and fundamentals. “Macroeconomics is the one which is most tangible; you can imagine that growth forecasts and inflation forecasts will be different under the climate transition scenario,” explained Paul, who added that Blackrock’s analysts have been calling inflation to be higher than the market was pricing for some years now… “We have been positioned in long inflation assets for this because we believe that the transition will ultimately be inflationary, with an orderly transition being less inflationary than a disorderly one,” he said.
What about repricing and fundamentals? Paul pointed out that the shift in societal preferences towards the E in ESG was also changing the relative cost of capital of different securities. “We have tried to come up with a systematic way of reflecting this change in the forecasts we make for different securities,” he said. “It has an impact, and we think we are starting to see that in market pricing today”. Under the fundamentals heading, the climate transition demands that asset managers adjust earnings estimates for various companies. This is easy enough to understand, because carbon pricing, carbon taxation and the upside potential for certain companies and sectors that are aligned with the climate transition will all have an impact on earnings and portfolio returns.
Energy futures are not clear
Paul is under no illusion that the climate transition will be smooth and concedes that having “no allocation to traditional energy stocks is not necessarily the most sensible thing to do from a portfolio construction perspective”. For example, there may be periods of time when supply ‘squeezes’ on certain types of energy push prices materially higher. “Indeed, from an asset allocation or stock picking level there is perhaps more money to be made from those companies that are, if you like, shades of brown that are going towards shades of green,” said Paul. As such, the portfolio must consider energy stocks that have credible transition plans.
“I am not a sustainability guy; but I do not believe that I can go out and put a client in a portfolio that ignores sustainability in the hope that we can make the necessary adjustment afterwards,” concluded Paul. “Sustainability is that fundamental that it has to be central and [addressed] at the strategic asset allocation level”. His sentiment was echoed by Moodley, who welcomed the opportunity to “advance the discussion on sustainability and the [related] environment, social and governance factors”. In this writer’s view, the IFAs in attendance had plenty of “thought provoking, dynamic and edge of your seat content” to wrap their minds around.
Writer’s thoughts:
It was refreshing to see issues such as climate change and sustainability acknowledged as part of the investment landscape rather than some strange phenomenon that existed independent of it. It does, after all, make more sense to structure portfolios for the world we live in, rather than for some optimal version of the world with all the risks stripped out. In this context, are we making too much of a fuss over integrating ESG factors into our advice and investment choices? Please comment below, interact with us on Twitter at @fanews_online or email us your thoughts [email protected].
