Mat Tilley
Asset managers need to demonstrate that ESG products offer a compelling and measurable investment case if the sector is to expand and reach maturity, according to Nomura Research Institute (NRI).
NRI, a trusted and internationally leading provider of system solutions and consulting services, recently acquired Australian Investment Exchange Limited (AUSIEX) from the Commonwealth Bank.
According to NRI’s report, What will it take to expand ESG investing?, while much of the growth in ESG investing over the past decade has been driven by conviction, expanding wider take-up of ESG products will be driven by risk/return profiles.
However, there is a shortfall in the way current ESG ratings measure performance. NRI is urging the industry to rethink its current approach.
“Academic research into ESG ratings and investment performance has yielded conflicting findings,” Atsuo Urakabe, NRI senior researcher and author of the report, said.
“Investors are broadly divided into two camps – those that believe stocks with high ESG ratings are more robust against market shocks and those that believe ESG investment strategies deliver very little alpha,” Mr Urakabe added.
“However, the growth opportunity lies with a third group – those investors who are more comfortable with high-ESG stocks than low-ESG stocks as long as expected risk/return profiles do not differ materially between the two.”
Mr Urakabe said these types of investors prefer to use ESG ratings as tertiary information after risk/return information when selecting portfolio assets, but are not willing to sacrifice investment performance in favour of ESG objectives. This group of investors includes institutional investors under pressure to invest through an ESG lens.
“The asset management industry should offer products, strategies, marketing, and reporting that meet these types of investors’ needs. In particular, the industry must be able to meet non-performance information needs to keep money flowing into ESG investment products.”
According to Mr Urakabe, using ESG indexes in the investment process offers a better correlation to performance.
“Investors in ESG indexes can benefit from replication of the market-cap-weighted index’s risk-return profile while taking comfort in owning high-ESG stocks,” he said.This approach ensures that performance objectives are met while investors know and understand that the portfolios that they are invested in are aligned to ESG values such as companies with small carbon footprints and non-discriminatory HR practices.
NRI’s report follows recent research by AUSIEX[1] that found a greater shift to Exchange Traded Funds (ETFs) using ESG indexes. The research found that:
During March 2020 to November 2020, there was a healthy uptick in ESG interest. There was a spike in trading ESG ETFs towards the end of 2020, and the general trend over the last three years is up.
Advisers trading through platforms on behalf of their clients were first movers in trading ESG ETFs.
Self-directed investors also boosted trade in ESG ETFs during this period, catching up with the advised (platforms) investor trend.
Policy imperatives
Meeting investor needs for more sophisticated ESG strategies and performance measures will become more urgent with policy changes likely to accelerate, according to AUSIEX’s Head of Markets and Client Solutions, Mathew Tilley.
Mr Tilley noted that more than 200 leaders from around the world will be attending the UN Climate Change Conference in November and that further carbon emission reduction policies could emerge.
In Australia, the Australian Prudential Regulation Authority has released for industry consultation draft guidance CPG 229 to banks, insurers, and superannuation funds on managing the financial risks of climate change.
Advisers will also need to respond to climate change. While not directly referring to climate change, FASEA Standard 6 requires an adviser to “actively consider the client’s broader, long-term interests”.
“Given the increasing scrutiny over climate risks and the likelihood of more policy initiatives to address these risks, investors will be presented with more ESG-focussed opportunities, but there will also be a greater recognition that ESG products need to offer a strong investment case,” Mr Tilley said.
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