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Stretching your investment beyond its monetary value

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Risk, by its nature, is exceptionally difficult to quantify. As a result, the consequences of prolonged risky behaviour only become evident when the damage has already been done and often at a substantial personal or financial cost.

I have yet to meet a person who does not understand the importance of a healthy lifestyle. However, how many of us find ourselves day in and day out indulging and making bad dietary choices? Eventually, the day comes when our illusionary bubble bursts, awakening us to the reality, leaving us with the thought that ‘surely, we should have known better’!

Similarly, Environmental, Social and Governance (ESG) investments are the ‘healthier’ options on the investment diet. ESG investments are generally known as sustainable investments because healthy investment choices are much more likely to deliver beneficial outcomes well into the future. These are investment practices that go beyond traditional investment principles and include a strong focus on attaining persistent positive returns while also aiming to have a sustainable positive impact on the environment, corporate governance and society at large.

The generally accepted understanding is that a company that fully integrates ESG practices within its day-to-day business should be in a position to improve overall risk management, attain persistent positive long-term performance and build/maintain long-lasting relations with key stakeholders. Furthermore, such a company would play an active role in socially and environmentally sound initiatives, thereby remaining in the front line; combatting matters such as global warming and social injustices.

Though ESG investments are the ‘relatively healthier’ option, not all investors are buying into the idea. There is an ongoing debate on whether integrating ESG factors into the investment process means trading financial returns in favour of positive social and environmental impacts. To get closer to a resolution on this issue, it’s critical to understand why ESG integration is so essential from a risk management perspective.

By definition, risk management is about setting behavioural or investment restrictions to manage unforeseen – but potentially adverse – circumstances. Provided the boundaries and no-go zones introduced by the risk management process are reasonable and set with clear objectives in mind, risk management is likely to deliver. A risk management strategy itself is a long-term approach that seeks to manage the unknown in the long run, which aligns closely with the process of explicitly managing risks related to ESG factors.

When it comes to governance, the benefits of employing ESG as a risk management tool are that it introduces conscious and ongoing ethical oversight of corporate governance behaviour in investee companies. In so doing, there is less likelihood of management indulging in illegal activities, such as fraud and corrupt behaviour, which could prove costly from both a financial and reputational perspective when they come to light. Incorporating measures to prevent this allows potentially affected stakeholders to be at ease, knowing that their interests are being protected.

The social factor ensures that companies treat their employees and their surroundings equitably. Managing the risks associated with this factor would ensure that the company behaves in a way that maximises employee retention and is generally less likely to become entangled in lawsuits instituted by disgruntled employees. The social aspect also encompasses a company’s attitude towards, and impact on, the community within which it operates.

Matters that directly affect us in the here and now tend to affect the decisions we make directly. When it comes to the environmental aspect of ESG integration, it becomes more difficult. The positive outcomes of our actions now are not likely to be visible for years to come. Thus, there tends to be a misalignment in the perceptions of how environmental factors will affect the average person or a company.

For instance, some investors fully subscribe to Keynes’s notion of ‘in the long run, we are all dead’ making them less willing to channel their hard-earned money into environmentally-conscious investments. However, what they do not understand is that environmental issues are arguably one of the most significant risks facing companies and the performance they deliver for investors.

The adverse impact of global warming on our overall environment is becoming clearer by the day. From uncontrollable wildfires in Australia, which killed more than a billion native animals, to extreme droughts in various parts of Africa – clearly, something is wrong! The side effects of global warming have become so familiar that only the very naïve could see global warming as an issue of the future and nothing to worry about until then. There has, therefore, never been a more appropriate time to factor environmental considerations into investing.

But, most investors are still not quite able to properly digest the overall value proposition of ESG-centric investments due to their inability to make long-term decisions based on what they can see and understand now. ESG is by no means a risk-free strategy that guarantees superior returns. However, it is a strategy that enables investors to limit the impact of difficult-to-quantify future ESG risks, as well as stretch the impact of their rands beyond their own narrow personal interests.

Until we reach a point where ESG integration is no longer considered to be a nice-to-have or an attempt to stay ahead of the curve but becomes a non-negotiable, we will have more convincing to do its valuable role in investment portfolios. DM/BM

 

This article was written by Vanessa Mabophe, Quantitative Analyst, Prescient Investment Management

 

Prescient Investment Management (Pty) Ltd is an authorised financial services provider (FSP 612).

The value of investments may go up as well as down and past performance is not necessarily a guide to future performance.

 

 

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