Investing Sustainably without Impacting Your Lifestyle

As citizens, individuals can express their political preferences around sustainability through the ballot box.  As investors, we can also express our preferences through participation in global capital markets.  But whilst many investors want the world to be a better place, they don’t want this to be at the expense of their personal financial security and lifestyle.  The question then becomes: can a conscious investor create a better world with his or her portfolio without sacrificing any of the returns along the way?  The answer, now, is yes.

For many years this has been a challenge in Australia, as the few sustainable funds available generally comprised highly concentrated portfolios with often dubious due diligence processes and high fees.

The team at Stewart Partners has helped influence and facilitate a new approach to sustainable investing for Australian investors, with four key pillars:

Pillar 1 – Underlying Investment Methodology

Stewart Partners' sustainability strategies are designed to help investors align their environmental and social values with their long-term investment goals without sacrificing sound investment principles or expected returns.

In good conscience, we could not recommend a sustainable portfolio to a client that did not adhere to the principles that give an investor the highest possible returns for a given level of risk.

Based on academic studies, this has ruled out most actively managed sustainability funds regardless of how well intentioned they may be in addressing investors’ social concerns.  The strategy we can now recommend to clients is globally diversified with thousands of underlying stocks, can incorporate both bonds and equities, and still targets the six drivers of investment performance that research indicates are reliable sources of higher expected returns.  

For instance, in equity portfolios, we still start with a broad universe of stocks ranging from very large companies to very small companies, and then systematically pursue higher expected returns by increasing the weights of those securities with smaller market capitalisations, lower relative prices, and higher profitability.

A strategy similar to the one we can now employ in Australia has been operating in the U.S for some time (US investors embraced sustainable investing well in advance of us).  Over the 10 years to 31 December 2018, a US equity sustainable strategy outperformed an equivalent strategy with no sustainability filters by 0.10% per annum.  And both of these strategies were able to outperform the benchmark after fund manager fees[i].

So investing by the application of filters to build sustainable portfolios does not imply a decrease in expected returns. At the very least the academic research suggests there should be no negative impact on performance. In time as more data becomes available we could find that sustainable portfolios offer a premium - time will tell.

Pillar 2 – Evaluate company environmental sustainability metrics

After considerable consultation with investors, it was decided that greenhouse gas emissions would be the primary filter used to build the sustainable portfolios.  The scoring system is shown in the table below:

In short the scoring system:

1. Emphasises environmental sustainability at both the portfolio and industry level

2. Focuses on reducing emissions exposure on an absolute and industry-adjusted basis

3. Applies a sustainability scoring system within each industry to emphasise investment in companies with higher sustainability scores and minimise or exclude investment in companies with lower scores.

The impact of this scoring system results in the following reductions in greenhouse emissions for each asset class in the portfolio compared to the market portfolio[ii]:

Greenhouse Gas Emissions Intensity - 63% to 90% reduction

Potential Emissions from Reserves - 99% to 100% reduction

 Pillar 3 – Reward companies acting in environmentally sound ways

To the universe of companies available for investment, a holistic scoring system is applied rather than adopting a binary in or out screening process. 

First, the least sustainable companies are excluded entirely from the portfolio.  The remaining companies are overweighted or underweighted based on how well they rank amongst their industry peers.  For example, a mining company may be sourcing its energy from renewable sources and using a fleet of vehicles that use alternative-fuels to reduce their carbon footprint. The question is should this company be excluded from the portfolio or rewarded for the efforts it is taking? Remember even in a cleaner world we still need mining, as the recent BHP TV commercial reminds us, electric cars need four times the amount of copper as petrol fuelled vehicles.

The benefits of our preferred scoring system is that it can preserve diversification while encouraging and rewarding good behaviour and recognises that capital markets and the supply chain are highly interconnected. However, for clients who prefer to exclude mining companies in their entirely regardless of their sustainable efforts, we can source solutions for this approach too.

Sustainability preferences are not generally restricted to greenhouse gas emissions. Many investors may also have concerns about land use and biodiversity, toxic spills and releases, operational waste, and water management, among other issues, which are incorporated into our scoring system with a combined 15% weighting.  However greenhouse gas emissions remains the highest component of the scoring system with an 85% weighting.

Importantly, this process of screening and exclusions can be applied to the fixed interest component of a portfolio as well as to the equity component. The principles and the approach are broadly the same.

Pillar 4 – Exclude companies based on social and governance considerations

Many sustainability minded investors also seek to exclude companies associated with certain social issues such as tobacco, alcohol, gambling, adult entertainment, child labour, factory farming, nuclear weapons, cluster munitions and landmines.

When considering social issues, we can take more of a black-and-white approach, as these issues tend to encompass only a small subset of companies in the portfolio. Companies that draw a significant proportion of their revenues from tobacco, alcohol, gambling or adult entertainment can be excluded altogether, with the aim to target producers in these areas, rather than say a supermarket chain that derives a small proportion of revenues from these areas. However other issues, such as controversial weapons, can be approached by excluding companies with any tie to this area.

Other considerations for Australian investors building a Sustainable Portfolio

A further consideration for investors in Australia is to be mindful of the impact of sustainability and social screens in a domestic market that is already, by global standards, small and highly concentrated with a large exposure to resources.

For this reason, Stewart Partners has developed unique portfolios for clients who wish to fully embrace sustainability in their investment portfolio.

Summary

The key takeaway for investors is that investing well and incorporating values around sustainability need not be mutually exclusive. By starting with a robust investment framework, then overlaying the considerations that represent the views of sustainability-minded investors, this allows for a cost-effective approach that enables investors to pursue their sustainability goals without compromising on sound investment principles or accepting lower expected returns. This includes highly diversified domestic and global equities and bond market securities.

Author: Rick Walker

[i] Source:  Sustainable portfolio proxy is Dimensional US Sustainability Core 1 fund, which returned 13.29% pa after fees over the 10 years to 31 December 2018.  The equivalent portfolio with no sustainability filters is the Dimensional US Core Equity 1 fund which returned 13.19% after fees for the same period.  The benchmark return is the Russell 3000 Index, which returned 13.18% pa to 31 December 2018.

[ii] Source: Dimensional emissions estimates as at 30 June 2018 for the Dimensional Global Sustainability Trust, Dimensional Australian Sustainability Trust and Dimensional Global Bond Sustainability Trust.