Value Column von Hans Peter Schupp
6 NOVEMBER 2024
ESG: A good idea with side effects
Doing good and earning more with sustainable investments? Hans Peter Schupp, CEO of Fidecum AG and portfolio manager of the Contrarian Value Euroland Fund (ISIN: LU0370217092) explains why this is not so easy.
It all started with a brilliant idea. If investments were only made in companies that meet higher environmental, social and governance (ESG) standards, the world would become a better place. And since such companies have better business prospects in the long term and entail fewer risks, this approach could even generate higher returns. Doing good and earning more.
In 2006, the UN Principles for Responsible Investment (UN PRI) therefore called on institutional investors worldwide to incorporate ESG criteria into their investment processes. 17 years later, at the end of 2023, the total amount of sustainable mutual funds and special funds in Germany had already reached 905 billion euros, according to data from the Forum Nachhaltige Geldanlagen (FNG). Funds that “somehow” invest sustainably thus account for 21.8% of the overall German market. The idea is clearly starting to catch on. But a closer look reveals some inconsistencies.
What exactly is sustainable investing?
The term “somehow” was of course chosen deliberately. This is because the most important questions relating to sustainability have still not been answered satisfactorily: What does sustainability mean? When is a company sustainable? And when is a fund sustainable?
Even the seemingly simple instrument of exclusions is open to debate. According to FNG, the top ten exclusion criteria include weapons, fossil fuels and nuclear energy. Is this really justified? What do we do without oil? For example, around nine out of ten pills today are made from oil derivatives. Can we really do without weapons when our own defense capability is a cornerstone of the protection of our democracy? And should modern, much safer nuclear power plants really be categorically rejected as a replacement for the climate killer coal?
In order to provide fund companies – and therefore also investors – with reliable guidelines, a huge bureaucracy has now been established. It establishes formal, standardized criteria for the “sustainability” label. However, the world of SFDR, EU taxonomy, TCFD, PAI and OffVO is not only difficult to understand for investors. For fund companies, it causes an enormous amount of work that would perhaps be better spent on managing the investments.
In order to be able to deal with this issue in a legally secure manner, most fund companies now rely on ESG ratings. Consequently, a lucrative line of business has emerged here. An expensive oligopoly of six major agencies has now established itself (MSCI, Sustainalytics, S&P Global ESG Scores, Refinitiv ESG Scores, ISS and Moody’s).
Why ESG ratings should be critically scrutinized
In the small-cap sector in particular, the agencies‘ statements should be treated with caution. Small companies often cannot or do not want to afford expensive and detailed sustainability reporting. In our experience, the rating results are correspondingly incomplete, outdated and in some cases simply wrong. Does this mean that a commitment to such companies is not sustainable?
A stronger focus on ESG criteria also has side effects in corporate management. While operational targets have recently been massively missed in many cases, board members have been able to “save” parts of their variable remuneration by meeting ESG requirements. Solar systems were installed, bee sponsorships were taken on, donations were made, unspecified diversity was increased and ethics training courses were held. Because business was worse, CO2 emissions were also reduced almost automatically. Is this the right incentive structure?
Sometimes things happen within the agencies that are also difficult to understand. In May 2021, for example, Nvidia was excluded from the MSCI World SRI Index due to a downgrade of its ESG rating. However, Nvidia’s absence from the SRI index then had a significant impact on the index’s performance compared to the traditional MSCI World over the course of the year. MSCI reacted and announced a change in the methodology of its SRI indices. In future, the focus on ESG standards should be better balanced with the stability and representativeness of the index. The share was reincluded in the index in May 2023.
Better risk-adjusted returns through sustainable investments?
Today, Nvidia has a weighting of almost 17% in the MSCI World SRI. In the MSCI World, on the other hand, it is only just over four percent. Investing sustainably worldwide is therefore primarily a bet on Nvidia. The fact that the MSCI World SRI Index is fundamentally more technology-heavy than the MSCI World also explains the majority of the relative performance and volatility of many sustainability approaches. They performed above average in 2021, 2023 and this year, but comparatively poorly in 2022.
Of course, we don’t know who will come out on top in the future. However, we still remember well that in 2020 and 2021, sustainably invested capital in particular created a green bubble among solar companies. Today, the common solar indices are trading more than 50 percent below their highs. If the financial data is unattractive, investing in sustainable companies is not sustainable either.
Our ESG approach: we analyze ratings and take a good look in the mirror in the morning
Let’s not get the wrong idea. Sustainable investing is basically a good idea. However, this topic should not be treated dogmatically, but with a sense of proportion and common sense.
That’s why we at Fidecum have chosen our own approach.
In the first step, we concentrate solely on the return potential of the individual companies. We then compare the ESG score of our entire portfolio with that of the benchmark. To do this, we use data from the rating agency Refinitiv. If our score is significantly lower, we analyze which stocks are specifically responsible for this. If we believe the Refinitiv assessment is valid, we replace the share with a stock with a better ESG score and similar return potential. However, the decision is always based on our own research.
Looking in the mirror in the morning is also an important criterion. After all, as fund managers we are aware of our fiduciary duty to our clients. Here is a good example: we found the Italian oil company SARAS interesting purely from a yield perspective. However, our analysis showed that the company was only able to generate above-average margins because it burned worthless heavy oil, which can only be used to a limited extent as tar or bitumen, in a power plant in Sardinia. Of course, it had government approval for this. Nevertheless, the environmental aspect was not acceptable to us. So we try to invest sustainably and at the same time achieve a long-term excess return.
Build up wealth in the long term
With our Contrarian Value Euroland Fund (ISIN: LU0370217092), we have remained true to our investment philosophy of investing in undervalued companies with potential and a comprehensible business model for 25 years. In doing so, we act like an entrepreneur who wants to buy the entire company and – if necessary – deliberately go against the prevailing market opinion.
About the author: Hans Peter Schupp, managing partner of Fidecum AG und portfolio manager of the Contrarian Value Euroland Fund.
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