Far from sacrificing returns, ESG enhances shareholder value

Hermes Investment Management, the £29.5 billion manager focused on delivering superior, sustainable, risk adjusted returns to its clients – responsibly, has today published ESG in emerging markets: Challenging the dominant investment paradigm.

In the paper, Gary Greenberg, Head of Hermes Emerging Markets, discusses how investment incentives for fund managers, based on maximising returns over a three-month to a three-year time horizon, currently make investing incompatible with solutions to the real problems we face as a civilisation – such as extreme inequality, pollution, water scarcity and climate change.

Investors may indeed ask: are we responsible for this anyway? Few of us are directly accountable, as we do not manage the world’s influential companies. Even fund managers rarely control more than a fraction of a large company. Furthermore, they may find themselves conflicted as confronting management on sustainability matters may compromise privileged access to detailed explanations of the business, not to mention guidance on operations and financial progress.

Do we have responsibility?

Investors face difficult questions. What are the full implications of investing in a company, and can they be divorced from the movement of its stock price? Within the paradigm of maximising shareholder value, does investing in a Singapore-based deepwater oil rig builder with a subsidiary creating landmines, or a Thai tuna canner overlooking the use of child or slave labour in its supply chain, convey no responsibility whatsoever to the manager? Does the investor bear some responsibility for what the company does, or is he or she simply a renter of shares, interested only in the potential financial gain?

Gary Greenberg, Head of Hermes Emerging Markets, said: “We consider ourselves to be long-term owners of shares on behalf of the underlying beneficiaries. We are ultimately responsible for the selection of a company’s board, and therefore its oversight of management and the actions of the company in its societal context. If we are to profit from gains the company makes, we are also responsible for the problems it may cause. We are responsible for ensuring, and must ensure, that both its gains and ours are not ill-gotten.

“That means extra work in analysing companies: understanding externalities, governance practices, environmental impacts, treatment of workers and influence on local communities.”

ESG engagement does pay off

Integrating environmental, social and governance (ESG) risks alongside financial metrics in the valuation of stocks is a relatively new concept, with the exception of some specialist fund managers. But it is beginning to generate substantial interest. For example, in June the California Public Employees’ Retirement System – commonly known as CalPERS – launched a pilot program that will, in time, ensure all appointed fund managers articulate how ESG principles are integrated into investment processes. With over $300bn in assets, the fund’s initiative will be influential.

Greenberg continues: “ESG works. We see plenty of first-hand examples of how successful engagement on ESG risks can improve the financial performance of companies, benefiting society as well as investors. This anecdotal evidence is corroborated by an academic study of the impact of Hermes EOS’ engagements with companies in the extractives sector – miners and producers of natural resources, and the businesses providing ancillary services. Hermes EOS is a global leader in corporate engagement and stewardship services.”

The study, conducted at the University of Reading’s Henley Business School, assessed 131 companies, of which 56 had completed engagements. It found businesses undergoing engagement generated an average annualised return about 4.8% higher and exhibited lower volatility and downside risk than unengaged peers. This finding resonated particularly strongly in emerging markets.

Additionally, research from our global equities team showed that avoiding developed markets companies with bottom-decile corporate governance rankings can add as much as 30bps per month to returns.

Further evidence of the efficacy of ESG integration in our universe is the outperformance of the MSCI Emerging Markets ESG Index over the MSCI Emerging Markets Free index.

Therefore, contrary to the received wisdom that ESG and engagement lie outside the paradigm of shareholder value, and indeed represent an additional cost to portfolios, there is strong evidence arguing that integrating these decisions into stock analysis enhances risk-adjusted returns.

Higher returns and sustainable legacy

“As more investors identify themselves as long-term owners of companies, and digital technology makes corporate activities increasingly visible to a larger audience, ESG analysis is becoming recognised as an important concept – particularly in emerging markets”, said Greenberg.

Many emerging market companies are learning these concepts for the first time, and we encourage investors to engage to help convey their materiality. This will reward their beneficiaries, the end-investors, in at least two ways: improving their returns, and helping to ensure that the healthy planet in which they laboured still exists when they retire.

Greenberg concludes: “To us, such potential outcomes make ESG analysis too important to ignore within the paradigm of maximising shareholder returns. ESG integration directs the focus of investing from outperforming this quarter to generating sustainable returns for many years.”

Read the paper