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Sustainable Investing: Not a One-Size-Fits-All Strategy

May, 2019 - Sustainable investing is a multifaceted approach that recognises the importance of considering environmental, social, and governance (ESG) factors alongside financial returns. However, it is crucial to understand that sustainable investing is not a one size fits all strategy. The methods employed in sustainable investing can vary widely depending on an individual or organization's unique investment goals. For some, the emphasis may be on maximizing financial returns while incorporating ESG considerations as a risk management tool. Others may prioritize aligning their investments with their personal values and actively seek out companies and projects that have a positive impact on society and the environment. The range of approaches within sustainable investing underscores the importance of defining clear investment objectives and conducting thorough research to identify the strategies that best align with those goals.

Socially Responsible Investing (SRI)

There are typically three approaches to using sustainability investing (SI). The oldest is socially responsible investment (SRI) which incorporates ethical values into the investment process. One key aspect of SRI involves the screening out of investments in "sin" stocks, which are businesses engaged in activities that are widely considered harmful or socially detrimental. This includes sectors such as tobacco, fossil fuels, and munitions. By excluding these industries from their portfolios, SRI investors aim to align their investments with their ethical principles and avoid supporting businesses that contribute to negative social or environmental impacts. This approach reflects a growing recognition that investment decisions can have broader societal implications, and individuals or organizations practising SRI seek to promote positive change while pursuing their financial goals.

Impact Investing

Impact investing is a unique investment approach that combines financial returns with the pursuit of positive social, economic, or environmental outcomes. Unlike the negative screening practice of socially responsible investment (SRI), impact investing takes a proactive approach by seeking out investments that actively contribute to the desired impact. Impact investors consider a range of themes or initiatives, such as the United Nations' Social Development Goals (SDGs), to guide their investment decisions. These themes may encompass areas like low-income housing, clean technology projects, health, education, and more. By investing in companies and projects that align with their chosen impact areas, investors aim to generate tangible and measurable benefits for society and the planet, while also striving for a competitive financial return. The focus of impact investing is on creating positive change, and through these investments, investors can play a crucial role in addressing pressing global challenges and promoting sustainable development.

ESG Integration

ESG integration is an investment approach that incorporates environmental, social, and governance factors into the investment analysis alongside traditional financial data. This recognition of non-financial data is driven by the understanding that ESG factors can have a material impact on investment performance and risk. Increasingly, institutional investors around the world are embracing ESG integration as a vital aspect of their investment strategies. According to a survey by RBC Global Asset Management, an overwhelming 90% of institutional investors in Europe, Asia, the US, and Canada believe that portfolios that integrate ESG considerations are likely to perform as well as or even better than portfolios that do not. This growing trend underscores the recognition that ESG factors provide valuable insights into a company's long-term sustainability, resilience, and potential for generating returns. By incorporating ESG integration into investment practices, institutional investors are not only seeking to align their portfolios with their ethical values, but they are also recognizing the potential for improved financial performance through a comprehensive and forward-looking investment approach.

Focus on Financial Materiality

SI is a dynamic process, sensitive to sector, market, and country-specific influences. The consideration of material ESG factors alongside a company’s fundamentals makes it possible to translate sustainability into financial performance.

The financial materiality of ESG criteria is the critical link between sustainability and driving business performance, which impacts the generation of cash flow and/or the cost of external financing (the weighted average cost of capital). When determining environmental, social, and governance risks, numerous factors can act as red flags.

However, only a few of them are likely important enough to have a significant positive or negative impact on a company’s business model, risk, required capital, revenue growth, and market share. For example, little is gained by assessing a financial institution’s co2 emissions or water usage. On the other hand, understanding its transparency in governance structures, disclosures, exposure to bribery and corruption or cybersecurity has an impact on the long-term financial sustainability of that financial institution. These ESG issues are material, plausible and of commercial relevance in quantitative investment decisions.

Lower Risk = Higher Return

In a noteworthy study conducted by N.C. Ashwin Kumar et al. (2016) titled 'ESG factors and risk-adjusted performance: a new quantitative model,' a group of ESG listed companies from 12 different industries were analysed. The study revealed that these ESG-compliant companies exhibited lower stock return volatility when compared to their non-ESG counterparts, with an average reduction of 28.67%. Additionally, the research highlighted that the impact of ESG factors varied across industries, with sectors like materials, banking, energy, and technology being the most influenced.

The difference in stock volatility ranged from 6.10% in the food and beverage industry to a substantial 50.75% in the energy industry. This percentage difference represents a risk premium that non-ESG companies face, emphasizing the importance for investors to consider ESG factors when making investment decisions. On average, equity investments in non-ESG companies carry an annual risk of 28% or higher compared to investments in ESG companies within the same industry. This finding challenges the popular notion that "lower risk means lower return," demonstrating that incorporating ESG factors can potentially mitigate risk without sacrificing returns.

Future Performance Success

There is a significant opportunity to generate value by focusing on improving an investee company's ESG standards. Actively identifying and managing material sustainability issues within an investment not only benefits shareholders but also allows them to reap the rewards of these improvements before they become evident to the wider market during retrospective financial reporting.

This approach is particularly advantageous for investors who adopt an active ownership style, commonly seen in private equity firms. In support of this, a study conducted by Dimson et al. (2015) concluded that companies with successful ESG engagement strategies witnessed higher investment returns. Interestingly, even companies with unsuccessful ESG engagements did not experience a decline in company value. Instead, these companies achieved similar gains to those that had not engaged in ESG practices. This suggests that active involvement in improving ESG factors can provide significant benefits to investors, enhancing both financial performance and sustainable outcomes.

The establishment of comparable sustainability reporting structures across industries in South Africa is an ongoing task that requires concerted efforts. However, one thing is clear: sustainability reporting is set to gain significant prominence as regulators increasingly prioritize environmental, social, and governance (ESG) considerations. Both investors and corporations seeking to make informed sustainability investment decisions should focus on material sustainability issues and the financial relevance of reported data.

By utilizing this information effectively, investors can enhance their understanding of the cost implications associated with megatrends such as climate change, rising inequality, and other non-financial risks, thus enabling more informed investment decisions. As ESG factors continue to shape the investment landscape, the smart utilization of sustainability data becomes crucial for ensuring the long-term viability and resilience of investments in the face of evolving sustainability challenges.

ESG integration not only supports responsible investing but also presents significant opportunities for driving positive change. Alternative investment fund managers, such as Summit Africa, are in an ideal position to play a vital role in directing capital towards unlisted active ownership private equity investment products.

By focusing on sectors like healthcare, education, infrastructure, and energy generation, these investment managers contribute to South Africa's national development goals. Investing in these key areas is crucial for fostering economic growth, improving public services, and addressing societal needs. Through their expertise and investment strategies, alternative investment fund managers can actively support sustainable and impactful projects that drive both financial returns and positive social and environmental outcomes in South Africa.

What’s on the menu – ESG or Impact Investing?

Embracing Responsible Investing for a Sustainable South African Future

The Business Case for ESG Integration

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