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Sustainable investing, beyond the box ticking and questionnaires

Capturing the investment return premium from sustainable companies.

Regulation 28(2)(c)(ix) of the Pension Funds Act (PFA) places a statutory requirement on retirement fund trustee boards to consider the sustainability of investments when managing retirement savings. The Financial Sector Conduct Authority (FSCA) recently released a guidance notice relating to these considerations specifically in the context of a retirement fund investment policy statement.

As part of the IPS – which is the founding agreement specifying the investment philosophy and objectives of the fund – the FSCA guides that sustainability be explicitly considered in the relevant investment mandates for Regulation 28 compliance. According to the most recent numbers from the registrar of pension funds, there are over 5 000 registered retirement funds (over 1 600 of which are actively receiving contributions and paying out benefits) with over 16.6 million members and a combined asset value of over R4 trillion.

Admittedly, not all the funds included are subject to supervision and regulation under the PFA, but this highlights the considerable asset base that, if managed responsibly, could have a significant impact on sustainability. The FSCA guidance notice, along with other industry-led initiatives such as the Responsible Investment and Ownership guide published by the Principal Officers Association of South Africa a few years ago, are not only consistent with the increasing global significance of responsible investing but, more importantly, compel asset consultants and managers to reveal their attitudes towards the incorporation of environmental, social and governance (ESG) issues when making investment decisions.

Unfortunately, there is no prescribed gold-standard methodology for effective ESG incorporation and measurement. This often leaves pension fund trustees to gauge levels of ESG integration using qualitative questionnaires for their consultants and asset managers. The United Nations supported principles for responsible investment organisation offers a comprehensive framework that includes suggested questions and other screening tools. This framework is aimed at assessing managers’ commitment to and the alignment of their ESG principles with that of the asset owners represented by the board of trustees.

It is worth noting that such guidelines and requirements reveal the promising strides being taken towards encouraging the industry to not only interrogate its thinking about sustainability, but to also formulate processes and ensure adequate resources and systems are in place to support the implementation of ESG integration. While acknowledging progress towards sustainable investing, it is alarmingly evident that without industrywide acceptance of the synonymous relationship between returns and sustainability, ESG considerations are regrettably likely to remain confined to little more than a box-ticking exercise.

Prescient considers sustainability an integral consideration to delivering positive long-term returns. It recognises that sound investing inevitably boils down to assumed risk and commensurate return. While it has historically been argued that responsible investing presents a trade-off with investment returns, there is increasingly compelling evidence that markets are to a greater extent pricing in the risk of unsustainability, and in doing so underscoring the sustainability risk premium.

Previously, the investment returns of a highly profitable mining company operating with inadequate health and safety procedures and high worker fatality rates could have endured the risk of these untenable operations. This paradigm has since changed. With the market progressively applying heavier discounts for unsustainability, investment returns for sustainable companies are increasingly enjoying said premium. 

The Journal of Investment Management recently featured a paper providing evidence that ESG factors are independent risk premia that can be thought of alongside other widely accepted risk premia such as Value and Momentum[1]. When considered within this framework, it is apparent that sustainability cannot be considered in isolation to investment returns, nor is it simply a matter of completing a questionnaire.

What is evident is that the sustainability of a company’s practices is increasingly critical for its long-term investment return profile.  Although improbable, overlooking this can potentially represent future personal criminal liability for pension fund trustees should they be found to have been negligent in “considering all factors which may materially affect the sustainable long-term performance of a fund’s assets”[2].

Seeiso Matlanyane is a portfolio manager and analyst at Prescient Investment Management.

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