BEST OF BOTH WORLDS
Understanding the landscape of environmental, social and governance investing is critical to choosing the right investment strategy, particularly when it comes to the impact of that investment. As ESG investing continues to evolve and institutional investors have a growing number of strategies to pursue, they may find it challenging to navigate the wider array of options and to apply the appropriate nomenclature to the different approaches.
“It’s an important issue, not because one should particularly care about labels, but because investors need to know what they are allocating their capital towards and, therefore, what they should expect from their investment strategies as a result of that choice,” said Tim Crockford, senior fund manager and head of equity impact solutions at Regnan, the impact and sustainable investing brand at J.O. Hambro Capital Management.
In the impact space, investors should expect to hear the terms “intentionality,” meaning a stated intention to demonstrate positive and measurable impact, and “additionality,” or the added positive impact that otherwise might not be present, Crockford said. He pointed out that defining and executing on these ideas can vary widely from market to market, and manager to manager.
“For us, impact investing means investing only in companies that are trying to solve specific challenges, either environmental or social,” Crockford said. While all impact investing will consider ESG investing practices, that isn’t necessarily true the other way around, he explained. For example, an ESG investor might choose one tech company over another based on its performance across a wide range of ESG metrics, but that investor may not explicitly seek out a commitment to positive impact.
“By contrast, we specifically ask, ‘What challenge is their product or service intended to solve? How does that core product or service make the world a better place?’” he said.
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UNDERSTANDING THE APPROACH
“While ESG investing, in broad scope, is more about the operations of companies, impact investing looks more at what the products and services are doing and the impact they have,” said Christian Roessing, senior investment manager, thematic equites, at Pictet AssetManagement (Pictet AM).
According to Roessing, thematic strategies are the closest that investors can get to real “impact” investing through listed equities. Historically, the purest form of impact investing has often been in the category of philanthropy, where impact is the only goal and there is no return requirement. However, thematic funds explicitly seek a declared intent to create an impact, with measurable outcomes, combined with an explicit goal of strong financial returns.
“There are very light-touch approaches that just use exclusion criteria to mitigate some ESG risk, and some moderate approaches that prioritize the best ESG performers within each sector. But [with these approaches] you’re still investing in oil and gas companies, or other companies with unconvincing ESG profiles,” Roessing said. “Thematic strategies, on the other hand, are the most tightly integrated in terms of seeking both impact and return. They ask whether invested companies, and their products and services, have a strong, intentional and measurable impact.”
Beyond a “pure play” approach — which seeks companies that have an explicit business focus on impactful products and solutions — other firms may take an all-in approach.
“We’re a little bit different in that, in terms of scale, we have $194 billion in assets under management, and we are committing all of our assets toward ESG integration. Essentially, we’re trying to make impact in all our holdings,” said Mary Jane McQuillen, managing director, portfolio manager and head of ESG at ClearBridge Investments. “Pure impact is something we strive for, but you have to have the right conditions, the right company, the right period of time, the right level of management maturity and the right amount of engagement to achieve it.”
She likens ClearBridge’s philosophy to a layer cake: The bottom layer is targeting impact with broad ESG integration and active company engagement across all the firm’s assets under management; the middle layer consists of more focused strategies that incorporate client investment policies and directives around heightened levels and types of ESG integration; and the top layer, the smallest layer, has the highest focus on intentional and additional measurable impact while still seeking to provide competitive returns.
“I worry when all asset managers get pigeonholed and painted with the same brush of being ‘impact’ or ‘ESG’ investors,” McQuillen said. “There are many differences in philosophy and strategy. I caution asset owners to understand those differences, and how each asset manager gets to that impact.”
IMPACT ON A SPECTRUM
‘Impact’ indexes can also deliver opportunities for investors, according to Jaspreet Duhra, managing director and global head of ESG strategy at S&P Dow Jones Indices. She pointed out that S&P DJI’s new Paris-Aligned and Climate-Transition Benchmarks — known as PAB and CTB and collectively referred to as the PACT Benchmarks — were designed specifically to offer broad exposure while also providing tangible and measurable impact on carbon-dioxide emissions and climate change, including an absolute annual 7% carbon-reduction goal. (See chart.)
“Impact is a spectrum,” Duhra said. “It’s completely worthwhile to invest in smaller mission- and impact-led businesses, but at the same time it’s important that one try to measure, as much as possible, the impact of investing in large blue-chip listed companies. We hold investors accountable for the negative impacts they may be generating. So if their investments are generating positive impacts through sustainable products, achieving net-zero goals or improving corporate behaviors, then those investors should also be credited with that positive impact.”
“We think it’s very important to think of sustainability and impact in terms of products and services, but also [in terms of] the operations of all the companies we invest in,” said McQuillen. “Very large-cap companies, for example, can have huge impacts [through] the operational changes they make, [which are] the ones that we, as active managers, push for. If a multinational company raises the wages of half a million people, that’s a very big impact, affecting a lot of labor. Or if a company operates hundreds of facilities and commits to transitioning to 100% renewable power, that’s a very big impact.”
S&P DJI’s Duhra argued that $100 million in sales for solar power or wind turbines, for example, generates the same impact whether it comes from a conglomerate or a pure-play alternative energy producer. “The key here is to be broad, because we won’t achieve our sustainability goals by being niche,” she said. “It’s important to understand the product portfolios of larger companies and what contributions they’re making to sustainability, because that opens up greater investment opportunity for a lot more institutions.”
STARS ALIGN TO TARGET IMPACT AND RETURN
“Investors are increasingly looking to combine impact and performance,” said Pictet AM’s Roessing. “In the past, the stars had not necessarily aligned yet, and the fundamentals were more challenging. Priorities were tilted more toward impact. But increasingly, investment performance is being placed on an equal footing because the fundamentals are there.”
He said he credits this shift to multiple converging trends in broad social awareness, technological and industrial innovation, and political will. Today it can make a great deal of economic sense to deploy impactful solutions — which are enabled by technology and are championed by politicians, regulators and consumers alike. As an example of political and regulatory power to shape the market, Roessing pointed out that more than three-quarters of global CO2 emissions are now covered by net-zero carbon reduction targets (see IEA chart), and technological innovation has significantly reduced the cost of environmental technologies, making them cost-competitive with fossil fuel-based solutions. (See graphic.)
“Fundamentals have dramatically improved, and we now see multiple inflection points in renewables, e-mobility, industrial software, etc.,” he said. “Investors see that it’s not only about making a strong impact — at the same time, they can achieve strong investment performance.”
The shift toward an integrated view of impact and return opportunity by asset owners is accelerating, according to Duhra.
“The trajectory that we see with our indices is an increasing desire to incorporate more metrics,” she said. “For example, the feedback on our net-zero aligned indices was that investors are excited about the opportunity, but [they feel] it needs to incorporate social screens as well as more comprehensive ESG scoring. In another example, in response to demand from asset owners, we applied a second filter to our clean-energy index to screen out outliers in the area of carbon intensity. So even as these newer impact-focused indices gain traction in the market, the market isn’t standing still, there is an evolution of requirements.”
Impact investors are also benefiting from years of evolutionary progress, from purely focusing on subjective value to understanding how ESG issues affect financial value, according to Crockford of J.O. Hambro. The discipline has evolved from socially responsible investing, with a focus on excluding companies not aligned with the investor’s values, to ESG investing, with a focus on risk reduction around ESG metrics, to today’s explicit financial rationale for investing in companies that place ‘impact’ at the core of their business model, he said.
“For the companies we invest in, financial return is as important as the impact, because the financial return is dependent upon the impact,” Crockford said. “The increase in value for these companies depends entirely on the success of a product or service that solves an environmental or social problem.”
Source: International Energy Agency (2021), Net Zero by 2050, https://www.iea.org/reports/net-zero-by-2050. All rights reserved.
Crockford said that the investment case depends on target companies addressing steady demand growth with products and services that solve, or mitigate, a specific environmental or social challenge — with that growth resulting in increasing revenue and profitability. And, because such companies are ‘pure play’ and mission-driven, the expectation is that demand-led growth could ultimately drive up their valuation.
“For us, impact investing isn’t an asset class, it’s an investment strategy,” Crockford said. “Our aim is not just to outperform a small subset of equities that are doing impactful things. We want to show investors that this is a way you can allocate your capital for the long-term, with a goal of outperforming the broader global equity space.”
ClearBridge’s McQuillen emphasized that when approaching the impact space, asset owners and asset managers have to be as laser-focused on the investment discussion as they are on the impact discussion.
“In our view, no one should be investing in an impact strategy because it says ‘impact’ on the label,” she said. “Asset owners should be considering these strategies because the investment processes are as rigorous and robust as any of the other investment options they have identified through their due diligence process.”
McQuillen said that while in the past the impact objective could outweigh the investment objective, or vice-versa, today’s investors do not face the same difficulty in balancing the two. In fact, financial rigor is an investment hurdle that all ClearBridge’s portfolio companies have to cross, she noted.
“You can say you’re the cleanest, greenest, most impactful business on paper. But if you’re not well managed, all that excitement can quickly fall to the wayside if you don’t perform well for shareholders,” McQuillen said. “Managers need to keep one eye on sustainability and impact, but they also need the investment experience to understand why a given company could outperform its peers.”
TRANSLATING PHILOSOPHY INTO OPPORTUNITY
“One can’t just go by a label. One has to look under the hood to make sure that any impact-focused strategy is based on a solid investment approach,” said McQuillen. “These should be diversified portfolios reflecting the appropriate amount of risk that the asset owner is willing to take, and the investor should understand the process underpinning it.”
ClearBridge’s teams adhere to a high-conviction, long-term investing philosophy that seeks high-quality companies with durable businesses, sustainable competitive advantage, a strong balance sheet and superior returns on capital, she said.
“We have a lot of great ideas on companies that have impressive sustainability characteristics. But no one pitches an idea unless it’s met a stringent investment hurdle,” McQuillen said. “If we just went on ESG and sustainability profiles alone, we could have even more companies to look at, but we have to be disciplined and meet both conditions.”
McQuillen also emphasized diversification. “Markets can favor different themes at different times, which is why we make the case for a diversified approach, to diversify the risk but also diversify the portfolio’s exposure to different themes.”
“Where an impact manager finds opportunity can very much depend on that individual manager and the nuances with which they apply their philosophy,” said Crockford of J.O. Hambro. “Our goal is to identify companies offering unique and differentiated innovation in the solutions they sell. That could be innovation around R&D-driven intellectual property, like wind turbines and blades, or it could be innovation of process or access, like micro-finance.”
Crockford said his team runs a concentrated equity portfolio of about 32 names. Due to their focus on innovative new solutions, their targets are generally in the $1 billion to $10 billion market-cap range. The solutions offered by these companies are nascent in terms of their adoption curve, but they have been tried and tested to the extent that independent research has confirmed that these particular solutions can, in fact, drive the positive social or environmental outcome that the team expects. The team’s strategy is exposed to eight themes — such as energy transition, the circular economy and food security — which can allow for ample diversification, even within a concentrated portfolio. Further, within each theme, there are multiple solution areas where the team finds unique investment opportunities, he said.
“We also intend to be invested for [long] holding periods, potentially beyond 10 years, as these companies grow into the size that we expect them to grow. Within that long-term period, we then have the flexibility to be able to adjust our exposures by changing the balance and position size of these individual names,” Crockford said. He used the example of an independent offshore wind farm operator that has grown in market valuation from $15 billion to over $60 billion since the team first invested in it. It remains in the portfolio due to the team’s belief in the company’s potential for further growth.
Source: J.O. Hambro Capital Management/Regnan.
“Rather than size-driving the sell discipline, we focus more on the scope of the business,” Crockford said. “That is, whether companies are selling pure solutions for environmental or social challenges, or whether they have diversified into areas that don’t contribute towards solving or achieving any of the United Nations Sustainable Development Goals. We aim to focus the portfolio solely on companies whose value is dependent on these solutions, rather than having a broad mix of products and services that are not relevant to driving a particularly impactful outcome.”
Roessing said that a key investment screen for Pictet AM’s portfolio team is deployment of capital: They don’t focus just on pure-play companies that are best in class (for example, offshore wind), they also look at companies in transition to help them reduce their cost of capital. However, he said, those companies need to demonstrate a material improvement toward a better environmental footprint to become investible and earn cheaper capital or endure a higher cost of capital until they do.
“We take a thematic approach and operate on a kind of purity concept,” he said. “When we invest, we want to see that a minimum percentage of the company’s activity is already geared towards mitigating climate change and exposed to energy transition. Not only do they need to demonstrate activity on the green side, if you will, we also want to see a large majority of capital expenditure (capex) going in that direction. For every company, we calculate the percentage of sales, enterprise value and capex that is green. And the greener the company, the higher the impact.”
Within the theme of energy transition, which is Roessing’s thematic focus, he looks at a wide range of opportunities, including renewables, energy efficiency and electrification, e-mobility, green buildings and construction (for example, insulation materials, energy-efficient appliances), information technology (for example, enabling semiconductor technology) and green manufacturing. At the sector level, he said that opportunities are concentrated in IT, utilities and industrials.
“Our opportunities are also mostly concentrated in developed markets because that’s where we find companies with the best innovation and returns, as well as very good, or better transparency in terms of ESG,” Roessing said. “But we also make sure that the revenues of those companies are well diversified across global regions, to keep our portfolio exposures well balanced.”
In the index space, according to S&P DJI’s Duhra, providers have to balance the opportunity set with investor priorities and objectives. There is no one-size-fits-all methodology when it comes to constructing impact indexes: Some investors seek broad benchmark indexes that incorporate ESG metrics and have low tracking error relative to the parent benchmark; others take a thematic approach and focus on a particular area of the market; while still others incorporate a defined sustainability objective, she said.
“For example, we’ve been asked by investors to create indices that cover the whole economy. It’s not just about focusing on better companies within the economy, it’s about getting the whole economy to move in a positive direction,” Duhra added.
One such client was the Government Pension Investment Fund of Japan, or GPIF, which wanted a diverse, non-exclusionary carbon index that would have a lower-carbon footprint relative to the parent index while also encouraging negative performers and outliers to improve. The index’s weights shift depending on a few key parameters: for example, the carbon efficiency of a company relative to its industry group, and whether companies are disclosing greenhouse gas emissions, she said.
“The GPIF also wanted to incorporate an engagement tool within that particular index that would encourage improved performance. So we constructed the index in such a way to achieve those objectives, and it remains invested across the entire economy,” Duhra said.
In addition to indexes that cover the broad economy, S&P DJI is also working within subsets of public markets to create sustainability and impact indexes that cover specific opportunity sets and meet the objectives and priorities of different investors. It has developed several individual index series, each with its own focus area: for example, a carbon-price risk series, a fossil fuel-free index series, a clean-energy series and a sustainability-screened index series, said Duhra, adding that within fixed-income markets, green bond indexes are a particular focus.
“Each investor is different, and each is trying to accomplish something that fits their own goals and constraints,” she said. “So we don’t believe that one can say there’s just one particular opportunity set or methodology that works in the impact space.”
ENGAGEMENT IN MANY FORMS DRIVES RESULTS
“Sometimes people think that if you invest passively, you lose the ability to engage,” said Duhra. “That’s clearly not the case.”
S&P DJI has constructed its carbon-efficient indexes to make it very clear to companies what’s driving their index weight, whether it’s disclosure of greenhouse gas emissions, or carbon efficiency relative to industry peers or some other measure, she said.
“Some of our indices were designed explicitly with engagement objectives in them, and others can clearly be used for engagement purposes,” Duhra said. “You can look at any of our indices and understand the rules-based methodology. The indices are transparent as to which metrics are used. So it should be relatively straightforward for any index user who wants to be active in the ESG and impact space to engage with companies. Investors know exactly which metrics are driving index weights.”
Duhra noted, as an example, a shift toward better carbon-disclosure practices in Japan following GPIF’s push toward carbon-efficient indexing. “It’s gratifying to see such a potential impact on corporate behavior.”
For ClearBridge’s analysts and portfolio managers, engagement is a multipronged investment effort that encompasses the entire firm, not just one-off meetings, said McQuillen.
“We’ve always believed that if you want to have impact, or if you are committed to ESG and sustainable investing, you cannot have these activities done for you by proxy. You have to do it directly yourself,” she said. Every analyst and portfolio manager at ClearBridge is an ESG specialist; analyzing ESG risks and opportunities isn’t farmed out to another internal specialist team, she said. ClearBridge builds its own proprietary databases and models to support its internal ESG ratings, from AAA to B rated (see chart). The firm also engages companies directly on shareholder proposals, rather than solely relying on the recommendations of an external proxy voting service, she said.
McQuillen said she believes that companies have been pushed toward more sustainable and impactful practices thanks to decades of this kind of work by active investors.
“We’ve been on this journey for a long time, and getting companies from where they were 20 years ago to where they are today took a lot of active engagement,” she said. “Our average holding period is over six years, where the typical U.S. asset manager’s holding period is one-and-a-half years. And we are concentrated owners, typically one of the largest shareholders, which demonstrates a high level of conviction and enhances our ability to work with, and potentially influence, management. Right now, what the world needs most is for these companies to continuously improve.”
Crockford of J.O. Hambro noted that investors need to be realistic that every ESG solution will have both positive and negative impacts. There is no such thing as a product or service that has zero negative impacts. As an example, he cited the difficulty in recycling wind turbine blades at the end of their useful life.
“Over the course of the holding period, our goal is to engage with companies, trying to get them to push forward on the positive impacts and mitigate or offset the negatives,” he said (see chart.) “We successfully worked with a wind farm operator to move them toward better disposal practices for decommissioned turbine blades. As a result of that effort, they will be moving toward reuse and recycling, instead of putting those blades into landfills.”
“The final step is really about voting and engagement, and having a very committed way of investing,” said Pictet AM’s Roessing. Investors of any significant scale can have an enormous impact, particularly with companies that are in transition, he said, adding that his team engages with the management of such companies on an ongoing basis, aiming to accelerate their energy transition.
“We’ve seen a number of companies, typically in the utilities sector, embark on or accelerate their transition strategy to make themselves more attractive and gain access to cheaper capital,” he said. “Today we are investing in companies that used to be quite dirty but have [since] adopted greener business models because they see that the multiples of ‘green’ companies are higher.”
Roessing said he is hopeful that as impact strategies continue to prove themselves, U.S. investors will see greater appeal in them and increase their engagement with impact opportunities in the market, as well as with companies they invest in.
“There is a lot of discussion taking place in the U.S., and we’ve already seen some of those discussions translating into action,” he said. “We expect, and hope, that this trend will continue. Because in the end, the market is coming to the awareness that the principles of ESG and impact are no longer the opposite of performance, they can actually drive performance.”