The active management industry is under immense scrutiny. Cost pressures and the rise of smart beta are expected to push closet trackers to the brink of extinction.
In the forging of the new investment landscape, a narrow seam of active strategies is coming to the surface.
The industry is expected to coalesce around a number of elite managers delivering consistent long-term outperformance; a result of well-defined and repeatable processes.
However, there is another evolutionary and complementary force at work that aims to provide a source of long-term alpha: the ascent of responsible investing.
Originally seen as a niche investment sector, responsible investment is not just in the ascendancy, it is increasingly becoming mainstream; around 80% of asset managers and asset owners now incorporate a degree of environmental, social and governance (ESG) factors into their decision-making, according to a survey from BNP Paribas Securities Services.
Delivering profits with principles
While the nature, rather than the extent, of this ESG implementation is up for debate, the direction of travel is clear. Demand should develop further with trustee education and consistent performance.
Achieving superior performance through responsible investment requires a shift in mindset beyond merely being signatories to the UN Principles of Responsible Investments.
Institutions must move beyond box-ticking exercises and focus on investing in companies that are fully embracing sustainability as core to their operations and a source of competitive differentiation. This approach is the essence of delivering profits with principles.
Harnessing global themes
Responsible investing embodies the very essence of long-term active management.
From an active investor’s perspective, the role they play in capital markets - dictating an appropriate cost of capital for those companies creating value vs those that destroy value - may be disintermediated, as passive ETF funds take an increasing share.
From a longevity perspective, we believe we can identify multi-year sustainable trends with greater certainty and predictability, than forecasting short-term global macro-events such as monetary policy or political outcomes.
Macro storms such as political turmoil come into play as useful valuation entry points during bouts of indiscriminate selling.
By looking at companies that can address long-term global societal challenges, we can get more visibility around the earnings opportunity and potential for the re-rating of valuations.
We identify global thematic shifts around several sustainable outcomes. Examples include: health and wellness, from diagnostics to genomics; sustainable consumption trends such as the circular economy; energy efficiency and environmental solutions; training and educational shifts such as re-skilling opportunities; and sustainable infrastructure, encompassing issues from autonomous driving to smart devices.
Investing with this view is supported by a growing body of research around the globe.
Data studies indicate companies that outperform in ESG factors not only reduce risk through their operational management, but can achieve superior revenue and profit growth through the provision of sustainable solutions that the wider world increasingly demands.
Collectively, the result is a compelling investment thesis, which once recognised can lead to higher stock market valuations.
Globally, due to a varying adoption of ESG screening across the globe, we see differing trends in terms of rewarding companies for exhibiting positive sustainable characteristics.
In Europe, where the majority of investors deploy a degree of ESG screening, the sustainable re-rating trend is well-entrenched.
However, in Asia where less than 5% of assets are managed with an element of ESG screening, stocks are less recognised for their sustainable characteristics and hence this demand profile has not manifested in a higher valuation.
In Asia, this provides a significant opportunity for long-term sustainable investors. For completeness, the US lies somewhere between Europe and Asia in terms of ESG penetration.
Is it fair to expect increasing demand for sustainable and ESG related companies? According to the aforementioned BNP study, institutional investors plan to double their investment in ESG driven strategies in the next two years.
Responsible investing will drive re-ratings
The extent of the re-rating for sustainable and responsible companies depends on several factors. An increase in demand ultimately drives the re-rating of any company. Hence, as investors continue to embrace ESG, demand for companies with such characteristics should rise.
We believe responsible investing appeals to the very basic tenets of the investment wisdom. In a changing world, markets have already realised factoring in ESG risk into investment analysis is important.
The active edge comes when you combine ESG with fundamental analysis, experienced insight into sustainable themes, a disciplined valuation framework and conviction stock-picking.
The resulting portfolio’s measurement of success is the creation of mutually beneficial arrangements for investors, in the form of superior index-beating long-term returns and for society, in terms of wider impact. An era of profits with principles beckons.
David Osfield (pictured) is co-manager of the EdenTree Amity International fund alongside Robin Hepworth. In the 10 years to the end of May the fund has returned 102.5% versus an average of 87.6% in the peer group.