Defining a sustainable investment approach
Public awareness and interest in sustainable investing has grown significantly in recent years, a trend that has been reflected in the charity sector. This growth in popularity has been accompanied by a shift in the understanding of the concept and its place in the investment process.
Trustees increasingly want to know how the returns on their invested capital are being generated, the extent to which non-financial risks are being incorporated, and if it is possible to both "do well" and "do good". As a result, sustainability is, or at least should be considered as an integral part of the due diligence process behind any charity's investment portfolio.
The terms
"Sustainability" is an often opaque principle with subjective definitions, both for individual investors and institutions like charities. It has evolved beyond just so-called green investments and ethical funds to encapsulate a more fundamental approach to investing.
In broad terms, we could think of a sustainability spectrum ranging from an unconstrained approach to investing at one end - focusing on financial returns regardless of where the assets are invested, to philanthropy at the other, where all assets are donated towards good causes with no expectation of financial returns.
Within the boundaries of these extremes are various terms that look to capture a range of investment approaches. The most long-standing are terms like "ethical investing", which expresses a subjective preference about what assets a portfolio should not contain, and socially responsible investing (SRI), a subset of ethical investing that aims to constrain the investment universe in an attempt to avoid social harm. The way that both of these terms are implemented is inevitably subjective and personal.
However, sustainable investing today can be guided more by measureable rather than emotional principles. Investment is about knowing the risks that you as an investor are exposed to, accepting those risks, and assessing whether you are being rewarded for taking those risks.
Another commonly used term in this field, ESG or environmental, social and governance factors, include a full range of non-financial risks that should be considered in the portfolio construction process. These factors remain valid regardless of any emotional biases, and ignoring them may pose a threat to the achievement of investment objectives.
Simplistically, if there are two identical car manufacturers which could potentially be included within a portfolio, one which is actively addressing carbon emissions concerns and another which is not, an equity analyst is likely to, all other factors being equal, consider the former as a better long term investment since the management is actively dealing with this long term risk factor.
Catalysts for change
A range of factors have contributed to the rising popularity of sustainable investing, including government incentivisation, whether through emissions targets or the promotion of social impact investing, as well as an increased awareness of the negative long term consequences of persisting with the status quo. A recent example is a report from the UN International Panel on Climate Change.
In addition, there is greater public awareness and heightened social consciousness around these issues. Arguably, there is a greater desire to invest with purpose and effect positive change, especially amongst younger generations.
Investment horizons are also an important factor. Charities in particular share a long-term investment mentality to ensure that they can continue to contribute to society for as long as possible, and this is also helping to bring sustainability factors to the fore.
Know where you stand
For charity trustees, the tension between the search for returns and the desire to be "ethical" or "sustainable", however they choose to define the term so as not to contradict the underlying values of the charity, can raise significant debate.
Fundamentally, trustees need to have a solid grasp of the different principles, know where they sit on the sustainability spectrum and how this should be reflected in their investment policy. Once in place, trustees may decide to put their mandate out to tender and choose a suitable investment manager (or managers) which can effectively translate the objectives of the policy into an appropriate portfolio construction.
This selection process can be a daunting task, but it is an important one in order to ensure that the charity's investment objectives are met. Most emphasis is commonly placed on the price and performance of the prospective investment managers, given that these are most easily quantifiable.
However, an objective process of selection should also include an assessment of how the manager will invest the charity's assets in line with the outlined ethos and values, and in a way that is sustainable over the long term.
In a situation where the trustees lack the expertise to formulate an appropriate investment policy to start with, some investment managers will be able to provide advice on how objectives can be articulated and implemented. In addition, there are industry guidelines to bear in mind.
For instance, there have been recent changes to the Charity Commission's guidance that have opened up greater opportunities for trustees to implement mission related investment and accommodate a lower rate of return, so long as the strategy reflects the charity's values and ethos, and is justifiably in the charity's best interest.
Portfolio implementation
Many of the perceived shortfalls of sustainable investment are linked to the "traditional" definitions of ethical investing and the highly subjective way that one's core views are implemented. Crucially, the debate about the sub-par level of returns achieved by investing "ethically" can only be based on a series of assumptions deemed valid by the individual investor/fund manager.
In reality, sustainable investment in the modern context is more like an additional lens in an investment manager's due diligence process. In many cases, the conversation has moved beyond simply screening for so-called "sin stocks" and actively ensuring that the research process takes into account the full range of risks that each underlying asset will be exposed to both in the short and long term.
Detangling the language
Detangling the sometimes confusing language and clearly establishing a succinct approach is especially relevant for charity trustees, who are typically focused on generating a financial return without breaching the charity's aims or constitution.
The issue of sustainable investment is by no means a static concept and it is a way of thinking that will most likely become mainstream. Endowed charities and their trustees have the opportunity to significantly affect the way these principles become embedded in investment processes and products in the future.
