RI Australian Equity funds: positive performance and reduced volatility

Leading research house Lonsec yesterday released its 2014/15 Australian & Global Equity Responsible Investment (RI) Sector Review, highlighting positive performance and reduced volatility for RI Australian Equity funds.

The report revealed that the Lonsec’s Australian equity RI peer group average returned 15.7% for the year to August 2014 and 17.1% p.a. for the three year period, outperforming both the ASX 300 index (14.2% over 1 year to August 2014 and 14.0% p.a. for the three year period) as well as the Lonsec ‘core’ Australian equity peer group (13.8% and 16.6% p.a. over the same periods respectively).

“It’s a common misperception that responsible investment will not achieve a reasonable rate of return on their funds but in reality this is clearly not the case,” said Steven Sweeney, Senior Investment Analyst at Lonsec and principal author of the report. “Pleasingly, while a niche segment, a number of the funds have generated a strong alpha track record over a reasonable period.’

Published for over a decade, Lonsec’s RI universe includes funds adopting a variety of intensity in their responsible investment philosophy from traditional ethical funds that screen out perceived ‘bad’ companies through to ESG funds that look to invest in sustainable companies across the market spectrum that rate highly on ESG factors.

“The challenge for advisers is to recommend the right funds that align with their clients’ ethical investment motivation,” Mr Sweeney said. “Traditional ethical funds have different approaches to ESG funds. For example, some fund managers, such as Perpetual, Australian Ethical and Hunter Hall are providing fossil fuel free options within the Lonsec universe while other Funds are not exempt.”

“Lonsec aims to provide a roadmap for advisers to help them provide suitable fund selection suggestions to meet their client’s objectives,” Mr Sweeney said.

Other key findings of the report include:

• RI funds are more likely to struggle when compared against the benchmark and mainstream peer funds in strongly rising or resource driven markets.
• Most Australian equity RI funds recorded lower volatility than the index over one and three year periods to August 2014.
• There is a recent trend to improve internal RI resourcing to supplement the external service provision.

The 2014/15 Australian & Global Equity Responsible Investment Sector Review covered seven Australian equity and two global equity funds. Lonsec awarded its premier ‘Highly Recommended’ rating to the Perpetual Wholesale Ethical SRI Fund. Five funds were assigned a ‘Recommended’ rating.

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“As a continuation of our organization’s long-standing commitment to corporate stewardship, we are pleased to sign on to the UN investment initiative,” said Grant Forster, chief executive officer of Principal Global Investors Australia. “It is intrinsic to who we are as an asset manager and aligns with our investment strategy and culture.”

Signatories commit to considering the six Principles of Responsible Investment related to environmental, social and corporate governance (ESG) issues in the course of doing business. Although the Principles are voluntary and aspirational, reporting on an annual basis is required. Governance is provided by a 13-person board made up of 11 elected signatory representatives and two representatives from the UN Environment Program and the UN Global Compact.

“As a leader in the global asset management industry, we believe appropriate consideration of these issues is part of delivering superior risk adjusted returns” Forster said. “We are committed to acting in the best long-term interests of our clients and will apply the Principles where consistent with our fiduciary responsibilities and in alignment with our investors’ expectations.”

For more about PRI or to view a complete list of signatories, go to www.unpri.org.

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Its aim is fourfold: to update figures for the 2009-10 financial year for the various forms and segments of responsible investment; to present analysis of its level of growth (or decline); to show comparisons with the total managed investment market; and to provide a summary of the latest reported overseas figures. For the second year in a row it contains a separate report showing benchmarks for clean technology investment. We have added for the first time a RIAA membership directory to the 2010 edition highlighting the key players in this industry.

Financial Adviser Responsible Investment Portfolios

Figures for this segment were gathered by surveying financial advisers with a declared interest in advice on responsible investment. Of that group, 23 firms responded that they advise on direct responsible investment portfolios which total $1,461 million. This is up 50% from the adjusted 2009 figure of $972 million.

This equates to about three times the level of increase in the Australian sharemarket in that period, suggesting there has been strong growth in the amount of assets invested in this manner. This compares favourably with a decline of 21% in 2009 and 3% in 2008 during the financial crisis; after strong growth of 46% in 2007 and 42% in 2006.

The longer term trend of strong (albeit volatile) growth in this segment indicates that screened direct share portfolios are becoming a more favoured means for financial advisers to meeting responsible investor needs. This is consistent with a broader trend away from managed funds and towards direct equity portfolios in the mainstream finance sector. The trend is most evident within private client businesses that are part of larger financial institutions and banks.

This segment also suffers from under-reporting as advisers that are known to provide this type of service are sometimes unwilling to share what they regard as commercially sensitive information.

A copy of Responsible Investment 2010 can be downloaded from the RIAA website. (http://www.responsibleinvestment.org)

Alternatively, you may download it directly from AdviserVoice.

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A greater focus on ‘responsible investing’ has seen many companies becoming good corporate citizens; examples include companies that rejuvenate land they have mined or contribute to the wellbeing of communities in which they operate.

Increasing investor appetite for such companies led to the emergence of a number of funds, varying described as ‘ethical’, ‘socially responsible’ or simply ESG (which stands for environment, social and governance). Each year, Lonsec researches and rates a number of funds so categorised, to help advisers find the applicable products for their clients.

How to categorise ‘responsible’ funds

The following broad definitions are a guide:

1. Ethical: Negative screening of companies in certain industries deemed to have a harmful societal impact. Avoiding investments in bad companies is the overarching investment motivation.
2. Socially Responsible Investing (SRI): Generally negative screening of certain sectors in line with above but may also include a positive screening element seeking to include socially responsible companies. Rewarding good corporate citizens is a partial investment motivation.
3. Sustainable investing (ESG): A belief that those companies with advanced approaches to environmental, social and governance risk management will exhibit superior performance than companies with sub optimal approaches. While it is likely that these companies will tend to rank highly on corporate ethics, unlike ethical investment, financial performance is the overarching investment consideration.

Lonsec takes fund categorisation a step further, focusing on the depth of responsible investment factors incorporated into the investment process; the output of which is a light, medium or dark green rating.

These classifications are aimed to give a general indication of Lonsec’s assessment of the level of ethical / Socially Responsible Investing (SRI) / Environmental, Social and Governance (ESG) criteria applied to, and evident in, the Manager’s investment process. The classification is not intended as an investment rating or recommendation.
Lonsec categorises the funds in its Responsible Investment universe as follows:

Client considerations –not a one-size fits all

ESG and sustainable investment funds now tend to dominate the Responsible Investment sector replacing traditional ethical and SRI approaches. Broadly, the market seems to have less appetite for funds focused solely on avoiding corporate bad guys compared to those investing in sustainable companies.

Despite progress, the sector still presents challenges for those providing financial advice. Investors in this sector are broadly grouped together under a ‘Responsible Investment’ categorisation, though bring different investment motivations which can make it tricky for advisers to confidently select investment managers for clients. Importantly, Lonsec believes that with some research, responsible investment investors can relatively easily determine a more suitable investment option for their needs than provided by a mainstream equities fund. The following are suggested priority areas for consideration in discussion with clients interested in this sector:

How Green is my client? It is important to sample investors’ green motivations. While Responsible Investors are commonly linked by a motivation to take account of a broader range of factors than solely fundamental financial analysis in their investment decisions and a concern about the community impact of corporate activities, the investment motivations can vary greatly across the sector. Ethically motivated investors may be aggrieved to allocated capital to major miners such as BHP and RIO, while ESG investors may be comfortable with such holdings given those companies’ risk management practices, community engagement, workplace safety record and so forth.

Does investment team buy-in matter? The level of ESG engagement in portfolio management teams varies across the sector. Lonsec believes this aspect is an important credibility test for investment managers and most likely a central consideration for investors in these products. In general a portfolio manager who is motivated and engaged with the Responsible Investment agenda brings added focus to the fund and is an important factor in increasing alignment of interest with investors. While Lonsec is primarily interested in the investment credentials of the Manager, whether the investment team is displaying a degree of engagement with the responsible investment sector is a relevant consideration in Lonsec’s appraisal of these products. This may be evident through the inclusion of positively screened companies at the margins of the portfolio where supported by the underlying investment research. Factors such as elevated corporate commitment to the sector, evident in participation in industry forums, production of research papers and company engagement can also suggest increased motivation.

Manage performance expectations. Spend some time with clients to discuss performance expectations. The depth of ethical screen can significantly constrain the investment universe and may have a performance impact during periods when certain sectors outperform (e.g. materials). Similarly, the screen can make it challenging to obtain adequate diversification in portfolios. The inclusion of a significant weighting to small caps in some funds may alter the risk/return characteristics of funds (e.g. resulting in higher tracking error versus traditional large cap core Australian equity funds).

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