The ESG opportunity: Three factors to consider when building your legacy

Balancing social considerations with financial goals can be a challenge, but one that investors are increasingly willing to tackle through an Environmental, Social and Governance (ESG) strategy, particularly in the UK. With the ESG industry still in its infancy, significant expertise is required to build a portfolio that balances financial goals with ethical principles.

RBC Wealth Management views potential investments through the lens of environmental, social and governance factors along with traditional investment criteria. Their ESG analysis goes beyond excluding companies in industries deemed to be involved in a controversial or unacceptable activity, such as weapons manufacturing, alcohol production or the extraction of fossil fuels - a practice known as "negative screening" or "ethical investing". They consider how companies can adopt best-in-class ESG practices such as stronger policies to protect the health and safety of employees, ethical patient trials and how to operate with the intention of generating positive social and environmental impact – a practice known as “impact investing".

While institutional investors were early adopters of ESG strategies, families and high-net-worth (HNW) investors are showing an uptick in demand. There is particular interest from foundations and family offices who want to align their investment strategies with their ethos.

In addition, female HNW investors are increasingly managing their own wealth-building and leading the way in incorporating ESG strategies and impact investing into their wealth planning.

Commissioned by RBC Wealth Management, The Economist Intelligence Unit (EIU) undertook a study of 1,051 HNW individuals, including 207 respondents in the UK, from March to May, 2018. The new face of wealth and legacy survey explores how the meaning of legacy and wealth are being redefined across regions, genders and generations.

It found 32 percent of women respondents in the UK say they align their investments with their philanthropic goals, compared to just 13 percent of men.

According to The EIU, 56 percent of HNW women in the UK think the ability to create change through impact investing is becoming more important in defining wealth, compared with 38 percent of men. It also found HNW women in the UK hold this view more often than women in other Western countries.

Here are three considerations investors should know about the burgeoning ESG arena:

1. Investing reimagined

While social investing traditionally used to involve negative screening – as this area has been around for the longest time - ESG investing takes a more proactive approach, says Eleni Karadimitri, product specialist at RBC Wealth Management in London.

“We want engagement with companies, to help them realise the risks and opportunities of ESG factors," she says.

For instance, an ESG fund can enhance returns and mitigate risk by using proxy voting and engaging in an active dialogue with companies to elicit a change in the company's behaviour on ESG issues such as climate change, resource depletion, labour conflicts, executive compensation, etc. The goal, she says, is to not simply invest in companies that align with ESG principles, but to help encourage those behaviours. This can help companies avoid controversies like the Volkswagen's fuel emissions scandal.

2. The ESG universe is widening

By looking beyond negative screening, the universe of potential ESG investments is broad and set to grow significantly, says Karadimitri.

There are, of course, some industries that are generally not appropriate for ESG investing, such as tobacco or fossil fuel energy. But ESG research can uncover investing companies across most of the business spectrum.

We have found global and regional ESG complying investments in both equity and fixed income, so we can create something that's quite similar from a risk and strategic allocation point of view to traditional portfolios, she says.

RBC Wealth Management has in-house ESG experts who work to find ESG investment options to fit any portfolio. When discussing potential alternatives and strategies with clients, it's in the context of their overall wealth planning and legacy goals, says Chrys Vakla, director, relationship management, at RBC Wealth Management in London. The approach is from a long-term perspective, understanding what the client wants to achieve and educating them on the methodology, challenges and opportunities available.

The number of funds currently focused on ESG is relatively small, but is expanding and will continue as demand increases, says Vakla. “There's definitely room to grow. We'll see more and more investment houses launching different products."

Demographics also point to increased acceptance in the future. ESG products are particularly popular with Millennials, who control an ever-growing amount of global wealth.

“Younger people want to do well with the investment, but also they want to do good with their money and contribute and give back to society," says Karadimitri.

Perhaps the main reasons to expect growth are continued efforts by the United Nations (UN) - and resultant corporate buy-in to promote responsible investment and sustainable development.

In April 2017, more than 1,700 firms representing US$68 trillion in assets signed up to the Principles of Responsible Investment, which was established by the UN in 2005 based on the idea that ESG issues should be considered alongside traditional financial factors.

And in 2015, the body adopted 17 sustainable development goals which are targets of every community, government and company such as access to safe and affordable drinking water for all by 2030. Doing so will require US$5-$7 trillion in investment, according to the UN.

3. ESG investing does not necessarily mean sacrificing returns

Undoubtedly, a concern for many is that investing with and ESG bias will result in a portfolio that generates a lower return.

There's little data at this stage tracking the returns of ESG portfolios versus other portfolios, although investment research firm Morningstar published a report this year that found U.S. investment managers who considered sustainability factors in their investment process in the three years between 2015 and 2017 outperformed their investment category by 57 percent, 55 percent and 54 percent respectively.

Karadimitri says there's no reason to think ESG should pinch performance.

When fund managers run an ESG analysis, they do this alongside a traditional financial analysis of the fundamentals of the company, explains Karadimitri.

This means these fund managers are still searching for the same valuation opportunities and growth potential than traditional managers. But the ESG process has the benefit of providing an additional layer of non-financial screening.

For instance, ESG may screen out companies with an elevated risk of environmental litigation, or companies that have non-independent audit and compensation committees that could eventually hurt stock performance.

Additionally, an increasing proportion of a company's value is intangible, which is challenging to measure in a traditional financial model. Factors like the company's relationship with its employees and clients are very important to a company’s value and this is where ESG analysis adds value that traditional financial analysis cannot, she says.

There's a Warren Buffet quote about playing the long game in investing that reads: “Someone's sitting in the shade today because someone planted a tree a long time ago." With favourable demographics and a push from international bodies, there's good reason to see ESG investing as a long-term way to add value and mitigate risk in a portfolio, but to also look beyond those traditional investment metrics.