Ethics Reduce Risk in Investment Portfolios

Incorporating environmental, social and governance analysis into investment decision-making reduces downside risk and maximise returns

Alceda Fund Management 15 October, 2013 | 1:53PM
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Read more on ethical and sustainable investing in Morningstar's Ethical Investing Week 2013.

This article is part of Morningstar's "Perspectives" series, written by third-party contributors. Here, Manuela Froehlich, Managing Director, of Alceda UK Limited, explains the importance of ESG analysis to investors.

Incorporating environmental, social and governance (ESG) analysis into in­vestment decision-making can build long-term value and reduce the risk of loss within a portfolio. As Milton Friedman said: “The social responsibility of business is to increase its profits.”

So why is it that so many investment managers are failing to integrate ESG factors fully into the management of their portfolios?

Studies show that firms embracing environmental and social ethics often perform better than their industry peers. Incorporating ESG analysis in the investment process can fulfill two objectives for investors: to achieve long-term competitive returns through managing risks; and to invest in a way that’s globally sustainable.

Luan Steinhilber, Director of Operations and ESG Analyst, Miller/Howard Investments, Inc. explains: “Risk mitigation is one of the key reasons we engage with companies in which we invest. We consider multiple factors for ESG investing including a company’s governance and ethics; environmental record; workplace policies; human rights record, especially regarding international operations; and the sustainability of their products and services for future generations.”

By identifying companies whose business strategy is non-sustainable (e.g. because they are overexploiting the environment or not taking into account employees’ rights) and by limiting the exposure to such companies in a timely manner, an investor can limit the downside risk to the portfolio.

For example, in August 2013 JPMorgan was subject to sanctions and investigations, including a probe about its hiring practices in Hong Kong and a request to pay more than $6 billion in penalties to settle allegations that it had mis-sold mortgage securities in the USA before the financial crisis. As a result, the equity value of JPMorgan dropped 11% from 56.54 (1/8/2013) to 50.53 USD (30/08/2013) in August 2013.

Luan Steinhilber maintains, “Building-in a clear interpretation of reputational or regulatory risk, along with analysis of the risk management practices adopted to mitigate threats, is essential to anticipating potential market failures.”

A series of studies performed by Nomura Securities and based on ECPI Group’s ESG data (September 2005 – July 2012) supports this view and confirms that there’s a correlation between ESG rating downgrades and falls in share prices.

Aldo Bonati, Head of Research Department, ECPI Group says, “As ESG integration is still not yet standard market practice, early adoption could offer investors a competitive edge against the market, both in terms of reputation and risk-adjusted performance.”

Luan Steinhilber of Miller/Howard Investments concludes: “We believe that the most effective approach is when ESG teams communicate directly with company management about problems and issues of concern. In our experience, investors want their companies to have policies that mitigate risk and ensure sustainability of the business model.”

Asset owners and investment managers are slowly starting to shift their attention to ESG risk. Whilst we believe that there is a growing desire among investors for ESG issues to be considered, there remains some way to go before investment managers integrate ESG factors fully into their management systems.

The information contained within is for educational and informational purposes ONLY. It is not intended nor should it be considered an invitation or inducement to buy or sell a security or securities noted within nor should it be viewed as a communication intended to persuade or incite you to buy or sell security or securities noted within. Any commentary provided is the opinion of the author and should not be considered a personalised recommendation. The information contained within should not be a person's sole basis for making an investment decision. Please contact your financial professional before making an investment decision.

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Alceda Fund Management  Alceda Fund Management is a leading independent structuring specialist in Europe dedicated to the structuring of traditional and alternative investments.