Jean-Francois Bordeleau and Mark Fairbairn discuss socially responsible investing – it’s history, the current environment and MD’s approach.
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In this episode of the MD Market Watch Podcast, we discussed socially responsible investing. I was joined by Senior Practice Manager, Jean-Francois Bordeleau and Assistant VP and Portfolio Manager, Mark Fairbairn. Together, we covered the history of socially responsible investing, current opportunities and trends, and last but not least, MD’s approach to providing investment choice to our clients.
What is the history of socially responsible investing?
Jean-Francois [0:50] Thanks Alex for the question. It only seems like yesterday, but I recall when I started working at MD in the late 1990s, I was working at a trade centre, and people – so some investors – would call in to ask about ethical funds and ethical investing. That's what I refer to as kind of the first generation of socially responsible investment. The thing with ethical funds is that they were what I call “exclusion” funds, they were kind of “sin” funds. So, they would exclude certain things; tobacco, gambling, alcohol. It started to have a bit of a view on environment. It was looking a little bit at some of the social factors – nuclear, nuclear energy, nuclear weapons were bad. So, there were a couple of criteria and it would weed out of the portfolios these types of investments.
Now if you recall, the late 1990s – tech bubble – and what happens with all these exclusions, this is why those responsible funds tended to invest into at that time. So, it did really, really well, till the late 1990s, until it burst in the early 2000s.
So then, the socially responsible industry did a bit of a self analysis, a bit of a mea culpa, and they said, well, how can we make the fund less volatile, a bit more diverse, so that we don't become concentrated in very specific sectors? And this is when the term socially responsible investing really came to light.
Here in Canada, that was exemplified by a company called Sustainalytics. And one of the products that they launched was an index called the Jantzi Index, which has been used by a couple of fund firms, and was reported in different medias around returns and the screening – that kind of stuff. So, what they did that was a little bit different is that, yeah, they still had a couple of exclusions, but they adopted a view or an approach that one should be invested in pretty much every single sector that an equity market has to offer, but let's look for the companies that have the best practices in that area. I mean, I kind of call this the "least-worse” approach, in a way.
And that kind of socially responsible investing – that best candidate, best practice approach – kind of lasted till, I would say, maybe about two or three years ago, when the ESG became all the rage. And what we're starting to see now a bit more is actually what I'll call the fourth iteration of this, which is impact investing.
So, it's no longer about doing or not doing what's wrong – it’s about encouraging what's right. So, you are starting to see a couple of investments such as clean technology funds, or exchange traded funds, for example, there are a few women in leadership funds out there. And these are just two examples, but you're starting to see a bit more of those what are call positive impact funds out there. And to me, that's potentially the next evolution of quote, unquote, socially responsible investing.
You mentioned the acronym ESG, which has become very popular. What is it and how does it fit into all of this?
Jean-Francois [4:05] Yeah, so E stands for environment, S for social, G for governance. This has been going around the world, I would say for at least the last 10 to 15 years. I mean, Europe ahead of the curve, many of the money managers have been talking about ESG, for many, many years. Here in Canada, one of the champions of governance, but also ESG in general, has been Mr. Stephen Jarislowsky, who created the firm Jarislowsky Fraser. In the U.S., I mean, it's starting to be there, they were a little bit behind, they're starting to take a bit more precedence.
So, what that means is that money managers would be looking for the environmental, social and governance footprint that their investment would have. And when we look at environment, for example, it's not just about oil and gas, I mean we see environment and we think, okay, there's not going to be any energy. It's actually much more complex than that. Environment could be things like water usage, for example, could be about waste management. You look at mines, like a goldmine, you need cyanide to extract the iron ore – not very environmentally friendly. So, these are some of the things – how do companies deal with the by-products of what they do on an environmental basis.
What kind of social practice do they have? I mean, do they employ child labour, or you know, so what are their labour practices in general, would be something. You could put women or people of colour in leadership, probably in a social aspect as well. Though now, this is starting to move into the governance factors as well; good boards, strong boards, diversified boards. So these are some of the things – some of the factors that would allow a company that specialises in scoring ESG, these are some of the things that they're looking for to assign, call it a “compliance” score, or a "do-good" score to the companies that are available to invest into.
What are the investment management opportunities and risks associated with socially responsible investing?
Mark [6:09] Thanks, Alex. Yeah, as with any strategy, there's both, there's opportunities and there's risk. The opportunity, I guess at the most basic level is ultimately to help push forward a more sustainable world, you know, economically, environmentally, socially. Much of what we consume comes from companies, you know, products, services. So, to the extent that you can make your voices heard as a consumer, you can also make your voices heard as an owner and use your voice as a shareholder to improve the practices of those companies.
Beyond that, there's also the opportunity to just avoid risks. So, poor ESG practices come with risk. So, environmental catastrophes, accounting scandals, weak governance, this all can cause reputational damage, but they also lower returns. The classic example or more recent example is Volkswagen’s emissions gate scandal back in 2015. That company was found to have been, you know, cheating their emissions tests. When that came to light, the stock fell 60% peak to trough. Even today, five years later, I mean, there's other factors that will impact their stock price since then, but it's still 40% lower than that peak level.
Ignoring ESG factors can have a material impact on your return. As asset managers and stewards of our client’s capital, we want to avoid these risks as best as possible. But – and JF alluded to this – as with any investment related topic, it comes with risks. And there's clearly been an explosion in interest in social responsibility, ESG, and with that, there's no shortage of new products and funds coming to market in this space. Lots of papers that you'll read, and they'll purport that ESG leads to better returns. It can improve risk-adjusted returns in consideration of other things, but blindly chasing the best ESG companies is not necessarily going to lead to a better return.
For instance, excessive enthusiasm can lead to disappointment. If everybody piles into the same names that are purported to be ESG leaders, the risk is that the valuations of those companies increase relative to the other ones. Even if they prove to be quite profitable, to the extent that you've overpaid for those profits and cash flows, the returns can be disappointing going forward. So, all this is to say, great social, environmental impact cannot ensure a great investment. But at the same time, bad social practices, bad governance, bad environmental practices, that's very likely to lead to a bad investment, particularly given enough time for the problems to come to light.
Ultimately, there's a huge opportunity to shape better practices and avoid the risk with investing responsibly. But at the same time, one cannot singularly focus only on investments that optically make you look the best on various sustainability scores.
What is MD's approach to this type of investing?
Mark [8:36] Our approach is what we call investing responsibly. And it's laid out in our Responsible Investment Policy, which is posted on our website at mdm.ca. This approach to investing responsibly is not a specific niche strategy, but a set of principles used in managing all of our portfolios. As stewards of our client’s capital, we feel it's important to be aware of all the risks, both more traditional market-based risks, but also environmental, social and governance related risks, associated with these investments.
Nobody wants to be a shareholder in the latest corporate scandal that’s in the news. It doesn't feel good to be associated with it, it's not good for your reputation and more specifically, it's not good for your investment returns. But it's also important to note that this isn't just avoiding companies and industries outright or trying to make ourselves look good by only investing in companies that rank well on sustainability or other ESG factors.
Our ultimate goal is to get the best risk-adjusted returns for our clients that we can as fiduciaries, while also using our positions as shareholders to affect positive change in companies as our position as minority shareholders. We do this in part by voting on shareholder matters, using the lens of sustainability. We utilise the services of ISS – Institutional Shareholder Services – to provide guidance on voting our client’s shareholder rights via proxy voting in accordance with the UN Sustainable Development Goals. We also work with our sub-advisors, more than 90% of whom, like MD, are signatories to the UNPRI which is the UN Principles for Responsible Investment, to ensure that our portfolio companies meet minimum levels of sustainability, that these factors are considered throughout the investment process and that collectively, we work to engage with those companies to further sustainability practices.
In addition to sub-advisors incorporating ESG factors directly into the security selection process, MD separately, independently monitors all our portfolios to identify companies as having lower ESG practices as an additional layer of oversight.
These weaker ESG practices can come from poor practices or policies, or evidences of involvement in key controversies, or misdoing across environmental, social or governance related areas. We then investigate these companies, identified with weaker ESG ranks or higher risks to determine if the position should remain in our portfolio. This includes engaging with sub-advisors to understand the investment thesis and how the identified risks have been considered and can even lead to direct engagement with the company themselves on their practices.
We don't require companies to have perfect practices, but we do need that any risks are compensated and that the company be willing to move in the correct direction over time. A company with relatively weaker practices and therefore higher risk should command a higher expected return. Also, the company should be on a path to improving their practices.
In certain cases, the business or company may be so egregious that we just don't want to be associated with it, regardless of how high the return potential is. One example of this would be tobacco. MD has excluded it for more than 40 years. Part of this comes from our association with the Canadian Medical Association. But it's also hard to get excited about investing in an industry whose product kills most of its customers and puts significant cost and burden on the health system and societies. Some businesses, the societal utility is just so low, the company is not willing to alter its behaviour, that it's just not worth trying to engage the shareholders. These are one of the few areas where we just avoid regardless of how attractive returns might be.
Let’s talk about the MD Fossil Fuel Free Equity Fund™ and the MD Fossil Fuel Free Bond Fund™. How have they performed and what do we expect going forward?
Mark [11:49] These products are unique offers within our product suite. So fossil fuel is a tricky subject. Unlike tobacco, where there's clearly no societal benefit to the product, and we'd be better off if it just didn't exist, energy does provide a use.
That said, recognizing that many clients have strong views around fossil fuels and concerns over climate change, and have a strong preference not to invest in the fossil fuel industry at all, we have created these products for those clients, such that they can purposely avoid the fossil fuel sector.
The funds themselves have performed quite well, particularly the Fossil Fuel Free Equity Fund, which is a global equity fund. Energy has not been a great investment in recent years, as low energy prices have weighed on returns, but also the prospects of stranded assets and the long-term viability of some of these companies, particularly those without a path to a renewable future, looks more questionable. As such excluding energy has been a tailwind. It's been good to not invest in energy.
But that's actually only a small part of the strong returns for these funds. Mostly the fund’s strong return has benefited from strong stock selection and focusing on identifying quality growth. [It] handily outperformed its MSCI world benchmark since inception, and it's had strong outperformance this year.
When it comes to the Fossil Fuel Free Bond Fund, performance is still good particularly considering low yields. But the benefits of being fossil fuel free within the fixed income space isn't really manifesting into better performance. Fixed income investing is very much a case of earning a yield, particularly in the investment grade space. Energy yields are higher due in part to the risks that we talked about, and to some degree, investors avoiding the sector creating a valuation opportunity. Not owning those higher yielding energy bonds will come with a performance headwind.
This along with the fact that the smaller size of the fund precludes more opportunistic investments than other fixed income sectors has held back the fixed income returns versus our core bond fund. In this case, the use of this fund will come down more to a personal choice around the desire to invest in fossil fuels or not. Performance results will likely be a bit lower.
Everyone has a unique set of beliefs when it comes to different social topics. What would you suggest for those looking for the “right” socially responsible investment?
Jean-Francois [13:59] Another great question, Alex. And the key word here that you've mentioned is unique set of beliefs. And that's the key part of the sentence.
So, let's say Alex, you were to come to me and say, Hey JF, what I'm looking for is an investment for whom the money manager keeps an eye on environment, social and governance factors. They try to be sustainable. It may not be divestment but keep a really keen eye on this. And when possible, that money manager plays a bit of an activist role to engage for change. Then you know, the MD family of funds does that, based on what we've heard from Mark.
Now, if you want to take it a bit further, and maybe the environment is something you deeply care about. And weapons might be something else that you care about. Our MD Fossil Fuel Free Fund does move the bar on the environment and also has a bit of a restriction on controversial weapon, for example. So, it is moving that a little bit further.
But maybe neither A or B fits for you. It could be that you have very strong views around, maybe, animal testing, it could be that you have very strong views around gambling. Could be very strong views around alcohol use and things like that. And our advisors have access to different tools, one of which is a tool called Morningstar Advisor Workstation, that screens investments available across Canada, be it mutual funds or exchange traded funds, across about a dozen factors. And does a little bit of a deeper dive on some of the carbon factors. So, if this is something where you feel very, very strongly about, and you need or want to have a specific exclusion, it is possible for us using our tool to screen for what's available out there.
Now, keep in mind that the more restrictions that you put, the more narrow the investment options may be. And it could be that we're kind of stuck with one or two investment options. And to Mark's point made earlier, we still do have a duty to make sure that that investment is suitable for you. That even though it may meet your personal set of beliefs, it will also be sufficient from a risk-return perspective. So, we do have to take that under consideration as well.
The last part though, that I would say is, if you're more into impact investing, there's very few tools out there. So, name search is something that we tend to do to find some of these options. And last but not least, I just spoke about name search. And I'm going to kind of contradict myself. You have to be careful – it’s not because it has ESG in the name, that it has sustainable in the name, that it has environment in the name that the fund does exactly what it is that you're looking for.
One example, you know, I was looking at one fund, a Canadian equity fund that has sustainable in the name. Its investment weight to energy is higher than the weight of the index. So, it could be investment in clean energy and things like that. But the weight is higher nonetheless, and yet it is sustainable in the name. It doesn't mean that it would be a bad investment, but then we'd have to dig in to see. So, what are these holdings? Are they responsible? Are they suitable? So, it can require quite a bit of work. But like I said, just be careful. If someone out there says, “hey, you should invest in this because look, it's in the name,” it's actually way more complicated than that.
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