Investment Trusts – ESG: Nice guys finish first
This is not substantive investment research or a research recommendation, as it does not constitute substantive research or analysis. This material should be considered as general market commentary.
ESG has moved from hippy pipe-dream to corporate mainstream, but what is it really and where do we see opportunities?
ESG investing, Environmental, Social, and Governance respectively, is much in vogue and has ended up weaving its way into almost every manager’s investment thesis, though with varying degrees of genuine integration. In this article we shine light on where ESG originated from, how Kepler Trust Intelligence goes about analysing ESG, and examples of trusts which demonstrate both good ESG credentials but also the nuances of assessing ESG.
The broader history of responsible investing, of which ESG investing is a part, can be traced back to the 18th century where religious groups such as Quakers and Methodists placed restrictions on the types of companies their followers could invest in.
Fast-forward to the late 20th century and to the rise of the collective investment scheme which suddenly concentrated a large amount of voting power to a number of professional managers.
Where traditionally shareholders would have an opportunity to vote directly (if they chose) at an AGM, fund management houses have traditionally not seen it as their role to exercise this influence.
However, changes in attitudes have seen responsible voting at EGMs become an important element of custodianship. Professional investors are now asked to pressure companies on key issues where deemed appropriate.
As a precursor to this, we began to see dedicated ‘responsible investors’ appear, and the development of products to satisfy this new demand. The real watershed moment for ESG came in 2006, with the launch of the UN Principles for Responsible Investment (PRI), whose foundations had been laid over the prior two years.
Signatories of the PRI, of which one can now count most major professional asset managers, are bound to follow six principles which demand the incorporation, disclosure and promotion of ESG issues.
Over the last decade or so the attention given to ESG has increased rapidly and not solely due to policy and initiatives within the financial sector, such as the PRI, but caused by a much broader societal understanding of the underlying issues.
Climate change is the most pressing of these concerns; one would have to be living under a rock to not be aware of the global demonstrations against climate change, and the ensuing government policies towards reductions in CO2 emissions and talk of ‘green deals’ for major economies – the list goes on.
While social issues gain less coverage, there has been localised demand for improvements in employee safety, especially with the increasing labour intensity in emerging market economies, as well as calls for more diversification within corporate structures in developed economies.
Despite the momentum behind E & S, Governance remains the most established of the three factors; the spectre of Enron and the changes brought about by its collapse remaining relevant to this day.
Years passed and it seems that the lessons have not been fully learned, as demonstrated by the collapse of Carillion in 2018. It is clear that there is still work to be done for something as seemingly obvious as analysis around the quality of company governance.
ESG: to what investment end?
As should inferred by the governance aspect at least, ESG has the capacity to enhance the returns of an investment process, even if it were to only avoid the next major corporate catastrophe.
The common motivation for ESG integration is risk management. Some of the largest corporate losses have been contributed to by governance failings and fraudulent behaviours.
Environmental issues are also becoming an increasing headache; just ask BP. As a result, at a stock level ESG compliant companies are increasingly finding themselves with a lower cost of capital on a relative basis. This confers a real competitive advantage to companies.
From a governance perspective, companies which pay more than lip service to ESG, can translate to superior policies surrounding independence of auditors, accounting transparency, and independence of the boards, allowing investors to more readily trust the stated accounts and their own valuations based on financial statements as a result.
Environmentally friendly policies see companies less likely to incur regulatory fines, avoid being forced into larger volumes of carbon trading to offset emissions and face less risk from the increasingly tighter environmental regulation. It might also give the company an edge in terms of the attractiveness of their products to consumers.
Social factors often play a smaller role in improving return potential, most commonly rearing its head in the form of high profile workplace assaults or labour infractions.
Yet we can expect the importance of social issues to quickly increase in the modern world of social media, the dominion of the few dominant names in the tech sector opening a Pandora’s box of privacy & social anti-trust issues, brought about by their products which are designed to encompass many aspects of our daily lives, the consequences of which are only recently being felt.
Seeing the wood from the trees
It is important to note the distinction between an ethical, responsible or impact-driven investment process, and an ESG integrated process.
Specific ethical, responsible or impact-driven processes will often define the objective of an investment trust (or fund), with the investment process built around the philosophical belief of the client or manager.
Everything from the investment universe to the end portfolio is proactively designed around these beliefs. ESG investing on the other hand, is far more flexible, and represents the integration of material ESG risk factors into a persisting investment process.
There is nothing stopping metals and mining investment strategies integrating ESG analysis into their process, though the extent of the integration and its effectiveness in producing an ESG compliant portfolio will vary (see our example of the BlackRock Energy & Resources Income below).
When one assesses ESG at an investment strategy level, the process becomes somewhat opaque, as the underlying holdings can at times be withheld, or simply an analyst does not have the time to meticulously assess each underlying holding in a portfolio when they will likely cover multiple trusts concurrently, each with dozens of holdings.
The process for assessing ESG must thus be adapted for collective investing, assessing both the manager’s ‘inputs’ and ‘outputs’.
The real crunch is being able to decipher if an investment manager is both sincere and effective in their integration of ESG into the investment process, and this is where much of Kepler’s efforts will focus on. While the Kepler Trust Intelligence process continues to evolve, the core factors which we assess will remain the same:
- The first and most important step is to determine the extent to which the manager is sincere about ESG and how they go about integrating this into their process aka the ‘input’. Questions may include:
- Is ESG a formal part of the investment process, or is it done more holistically on a case by case basis?
- Are the analysts and managers of a trust responsible for analysing ESG, or is it outsourced to another team or company?
- Has the portfolio weightings been materially altered by integrating ESG into their investment process?
- It is also important to determine if the parent company is serious about ESG, as they will often lead their investment managers towards further adoption.
- Is the company a signatory of the UN PRI?
- Do they have an active voting policy?
- How does the company report on its ESG issues?
- The ‘output’ relates to how the final portfolio looks, and how it ranks versus its peers. This is an important step in determining whether the manager has ‘green-washed’ his process by implementing a trivial ESG analysis to comply with market demand.
- Does the portfolio reflect the amount of effort that has gone into ESG analysis?
Being led down the garden path?
While ‘green-washing’ is a major concern when assessing ESG, there are also many other issues and nuances at work.
Certain sectors will naturally screen well for ESG, so even if the manager makes little effort to integrate ESG, the end portfolio may naturally look highly ESG compliant.
The two biggest culprits for this are technology and European stocks.
Technology stocks tend to have a small carbon footprint as well as young and more diverse workforces.
Additionally, European companies are beholden to Europe’s stricter standards around ESG issues, such as labour rights and emission regulations. They are also more likely to be in a position to report on ESG issues which may unjustly skew our beliefs, as reporting does not always mean action.
Another problem is that the definition of ESG investing is not yet entirely clear cut, with some potentially contentious issues which can lead one manager’s understanding of ESG to differ wildly from another.
This is often the case when managers differ on whether they consider certain industries ESG compliant from a moral view, accepting that there are no absolutes as to what constitutes morality, and can often depend on whose perspective one takes.
Tobacco companies provide a case in point in this regard. While tobacco consumption can be understood as a social blight, the companies themselves can have strong ESG credentials, with British American Tobacco being named one of best companies for diversity.
Additionally, the tobacco crop is also an important source of income for many farmers in emerging markets; despite its high initial cost, it can remain profitable at low yields and is perceived to be resilient to adverse weather.
Direct ownership of ‘alternative assets’ (such as real estate and private equity) can often bring additional complexity to traditional collectives analysis.
Thankfully when looking at these funds from an ESG angle, in our view it is one of the few places it can actually simplify analysis. The theory is that if the manager has direct control over what he buys then the underlying assets should fully reflect his ESG beliefs.
A manager should be able to implement a level of active ownership impossible for a manager that invests in publicly traded assets. A manager with a strong ESG integration should also be able to produce the respective filings to evidence this, instead of trusting the accounts a typical public company would submit.
With the host of factors and intricacies around ESG there are plenty of variations in its adaption and no shortage of examples of how trusts go about its implementation.
We envisage adopting a scoring system on both the ‘input’ and ‘output’ of the managers, before comparing trusts with peers. The end result, we hope that in the near term we will be able to offer a categorisation of trusts which demonstrate the greatest exposure to ESG in all its forms.
In the immediate term, we offer these examples of trusts which in our opinion score highly on different aspects of ESG, while also offering examples of the complexities and nuances of ESG analysis. All of these trusts might suit ESG investors, but in different ways:
Necessity is the mother of innovation: not exactly ESG, but offers solutions…
BlackRock Energy & Resources Income (BERI) – BERI represents a complex but perhaps necessary evil within ESG (E in particular). While the broader energy and resources sector has a storied history, the extraction of natural resources still plays a vital part in the transition to clean energy, with large volumes of copper required to upgrade electric grids and more traditional, power generation still needed to cover current shortages of renewable energy.
Besides their holdings in conventional resource extractors, a key structural weight within BERI is now specifically to “energy transition” stocks which amounts to c. 30% of the portfolio, an obvious acknowledgment of environmental issues.
Yet arguably more important is the manager’s approach to active engagement with their non-renewable companies to ensure that management teams recognise the need to transition to a lower carbon economy.
Few people would disagree that this is vital if fossil fuels are to fill the gap in our transition to clean energy. BERI offers a highly attractive (historic) dividend yield of 6.6%, and on a historically wide discount to NAV of 15.1%. We believe that should ESG investors start to recognise the trust as an “ESG improver”, there is considerable potential for the discount to narrow from here.
Above and beyond the standard expected…
NextEnergy Solar Fund (NESF) – NESF invests directly into primarily UK-based solar energy infrastructure assets (although it hopes to branch out geographically with future fund raises).
The benefit solar energy provides in tackling climate change is clear. However, what some investors might not realise is the further commitments made to improving the environment in how those assets are managed.
NESF’s manager, NextEnergy Capital Group, has a dedicated team devoted to biodiversity. These projects are designed to enhance the biodiversity of the local environment, via adherence to a Universal Biodiversity Management Plan for NESF sites.
As of the end of March this year, NESF’s sites housed 2.1 hectares of wildflower meadows with more development pending and a total of 4.8 hectares expected to be in place by this autumn.
There are six bug hotels at these locations, and another four on the way as well as seven beehives and three more pending. Four hibernacula were also in development, although we note that the pandemic has slowed project completion.
Early results are already visible: in the wildflower meadows seeded in 2017, the number of plant species has jumped from 20 to 37 and the number of bumblebee and butterfly observations has risen by 500% and 300% respectively. NESF trades on a 7% premium, below that of the two mature solar infrastructure funds and we have published a full note this week.
Greencoat UK Wind (UKW) and The Renewables Infrastructure Group (TRIG) – Both have made great strides in expanding their ESG reporting and accountability. Of course, the nature of their investment propositions speaks to their green credentials, given their portfolios directly profit from the shift to a low carbon economy.
However, both provide detailed guides on how they interpret ESG integration. For UKW, what is most promising is its clear disclosure of its ESG KPIs, something few strategies do regardless of sector.
With these KPIs we can assess how effective they are over time. TRIG on the other hand reports its ESG policies and actions in unusually granular detail.
It identifies which of the UN Sustainable Development Goals it fulfils, and outlines in great detail the various E,S and G initiatives it has undertaken over the year.
We hope to be update our research profiles on UKW and TRIG soon, please click here to be alerted to when we publish on UKW, and click here for TRIG.
Output scores well, but what about input?
Henderson EuroTrust (HNE) – Investing in European domiciled equities, HNE has constantly ranked as one of the best trusts on Morningstar’s sustainability rankings.
As a result, one might expect HNE’s manager to have ESG well-integrated in the investment process. As we note above, Europe naturally screens well for ESG, so without meeting the manager and analysing his process one could not infer whether the ESG credentials are coincidental or by design.
The reality is that ESG is not specifically formalised within the investment process, and it is only when speaking with the manager (Jamie Ross) do you realise that typical ESG integration is not needed, as his investment process is so focussed on governance and sustainability that it naturally aligns with ESG.
HNE has performed extremely well through 2020 so far, thanks to stock picking alpha derived from Jamie’s investment process which aims to provide an objective view of the best risk/reward opportunities.
The trust trades on a discount of 9.9%, wider than the peer group average of 7.9%.
We hope to publish updated research on HNE soon. Please click here to receive an alert when we publish research.
Input scores well, but what about output?
Jupiter Green (JGC) – JGC is a more typical sustainable investment strategy, investing in listed public equities on a global basis. As the trust’s name suggests, the manager aims to generate attractive total returns by investing in companies which are developing and implementing solutions for the world’s environmental challenges.
The manager’s approach to ESG is far more explicit than most others on this list, acknowledging the high amount of ‘green washing’ that occurs within the collective investment space.
While the manager is acutely aware of the issues surrounding ESG, instead of focussing on merely ‘good’ ESG companies, he chooses to hone in on those that are offering genuine solutions to sustainability as opposed to simply not impacting it. JGC is a relatively small trust, but sister to a much larger open-ended fund.
In early September 2020, the board and manager have agreed a shift of emphasis for the trust’s portfolio, favouring smaller and more nimble “innovators” and “accelerators”, over “established leaders”.
This means that whilst the portfolio will be still invested in companies providing solutions for the green economy, it will be exposed to higher growth opportunities, albeit with a likely higher volatility than JGC has exhibited historically.
The portfolio transition has already begun, and so we look forward to seeing the trust embark on the next leg of its journey – click here to receive an alert when we publish research.
Impax Environmental Markets (IEM) – IEM has been a long standing marquee fund in the investment trust universe for investors wanting a differentiated exposure to companies that will profit from the transition to a more sustainable economy.
The core investment thesis of Impax Asset Management has long been that the global economy must transition from a depletive economic model, to a sustainable one in which growth is achieved with improved social and environmental outcomes.
Internationally, there are politicians calling to ‘Build Back Better’, labelling it a once-in-a-lifetime opportunity to embed low carbon energy systems and cleaner air in cities post-COVID. Many of the specialist companies that endeavour to achieve this can be found in IEM’s diverse portfolio.
Because of its mid and small-cap focus, IEM offers exposures that are unlikely to be found in generalist global funds or trusts. With continued strong performance during 2020, IEM has remained on a persistent premium to NAV.
Fully integrated ESG process appears to pay off for performance…
Mid Wynd International (MWY) – While the previous trusts serve as examples of the nuances in ESG investing, MWY is far more straight forward with clear ‘inputs’ and ‘outputs’ to their ESG integration. It is an example of a typical but well integrated ESG screening process, which results in a portfolio which ranks amongst the top 10% for sustainability in the Morningstar global equity large cap sector.
The managers clearly delineate ESG factors within their investment process, has an active and recorded voting practice, and even goes so far as to operate an exclusionary screen for your typical sin stocks and major polluters.
In our view, MWY employs a style of ESG investing which investors are increasingly reaching for.
We believe that the strong performance the trust has delivered is good evidence for the effectiveness of a disciplined approach to ESG integration.
We are currently working on updating our research for MWY – please click here to receive an alert when we publish.
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