Hansi Mehrotra: Forget historical returns for RI

The United Nations Principles for Responsible Investment now claims over 550 signatories with more than USD 18 trillion in assets. UNPRI provides a framework for institutional investors to integrate environmental, social and governance (ESG) factors into investment processes. Also, the International Finance Corporation has sponsored a study on the prevalence of RI in emerging markets. High profile pension funds and sovereign wealth funds are starting to integrate ESG into their investment process.

RI has reached a tipping point!

However, there are still many skeptics who ask for proof. Have Responsible Investments outperformed ordinary i.e. pure capitalist investments, they ask. It sounds fair enough, but we’ve done the studies and the results are mixed – skewed towards the positive.

Mercer recently published a report Shedding Light on Responsible Investment: Approaches, Returns and Impacts where 16 academic studies were analyzed. The majority of which (ten) show a positive relationship between ESG factors and companies’ financial performance, four of which show a neutral relationship and two which show a neutral to negative relationship. This follows a previous study in 2007 which showed similar results (Demystifying responsible investment performance; both are available on mercer.com/ri).

However, the questions around proof about historical outperformance miss the point. Even for a capitalist like me.

Firstly, history is not indicative of future returns. The line is cliché but in the case of RI, it’s a self-perpetuating argument. 25 years ago people did not care as much about climate change as they do today. But then the Exxon Valdez and Union Carbide tragedies happened and the world changed. Bono pulled off a concert, Al Gore showed us the Inconvenient Truth, the world came together to switch off their lights for Earth Hour. So while people’s concerns, both as consumers and investors, did not affect company performance a generation ago, they might today. Similarly, governance has become a hot topic post Barings, Enron, Madoff, Satyam…the list goes on. The GFC has sparked thousands of studies on governance failures.

Today, Gen X and Y want RI. The growing public interest in issues and the emergence of younger generations into the high net worth space is facilitating a surge in interest in responsible investing among family foundations and high net worth individuals as well as at the retail level. Similarly, the global regulatory environment is changing to promote more corporate transparency and reporting standards.

Hence, the results of a study conducted during the past 20 years is meaningless in today’s environment. Even the slightly positive historical return proof probably understates what might happen to future returns.

Secondly, it assumes RI is about returns. It’s not; at least in the short term.

It’s about risk.

Currently most fund managers focus on financials, with a cursory subjective analysis of management quality. So if a company meets the regulatory minimums on environmental, social and governance issues, and the management team passes the ‘smell test’, the fund managers would base their investment decision on financial factors. This may have a good outcome. But accidents do happen…and usually to those who are not prepared. If the company has not formally considered ESG issues beyond what’s required by law (which usually lags real life), chances are it is not prepared for a change in the law or public perception.

However, if the company and fund manager/investor adopted a more formal RI framework, they would think about the probability and impact of risk: litigation risk, reputation risk, and regulatory risk to name a few. And then there is the opportunity cost of management time dealing with adverse events.

Having analyzed the risks on the share price over the long term, fund managers and investors may conclude to either not invest (as in screened investments) or engage with the company management (active ownership). These risks may not eventuate. But it’s worth taking out an insurance policy.

RI is about managing risks that could potentially impact growth in future earnings and so future returns. And post GFC, when companies like GM, ML etc destroyed shareholder wealth, investors are more sensitive to downside risk.

As a capitalist, I care about giving the right incentives so that capital is allocated to the right places. I think RI is about investors demanding that their pension funds and fund managers give the right incentives to company managements and allocate capital accordingly.

Responsible Investment is therefore not so much about the feel-good factor or philanthropy; it is hard core economics and risk management.

Hansi Mehrotra is a principal and Asia Pacific head of wealth management services with Mercer’s investment consulting business.