Welcome to the August 2022 Manager Panel! The Manager Panel is where we ask fund managers some questions surrounding a topic. This month we asked Ellerston Capital, Pathfinder and Foundation Series which is brought to you by InvestNow, about their approach to ESG factors and their views on how they see ESG factors evolving in terms of impact on their business and/or the wider industry. Check out the questions and answers below.

Q1: Within Ellerston Capital, what is your philosophy and process towards incorporating ESG factors within your funds?

Ellerston is a high conviction active manager offering a range of equity-related investment strategies. Each of our investment teams has its own investment process for its particular strategy, which is determined by each Portfolio Manager. As global investors, the Ellerston Global Mid Small fund incorporates numerous industry leading frameworks to assess the ESG risks and opportunities inherent within potential investments. Our in house ESG team helped us construct this process to ensure we remain at the cutting edge of international ESG standards.

The EGMS fund does not invest in sectors considered destructive to the environment and/or socially irresponsible. As a result our negative screen excludes the following sectors; Oil & gas, Armaments, Gambling, Tobacco and companies that conduct extensive testing on animals. For companies that pass the negative screen we conduct the following analysis:

1. Does the company understand its own ESG risks and opportunities?

This section is focused on understanding how the company identify, measure and report their own ESG risks. We determine if addressing these ESG risks is properly supported by the management and board by looking for ESG linked KPI’s within remuneration. Among other things, we assess the company’s ability to improve resource efficiency, regulatory impacts and social/human rights risks within the supply chain.

Key to our process, we then consider how the above ESG risks could impact margins and profitability, which is then incorporated into our financial forecasts. This directly links our ESG work to our financial analysis and investment methodology.

2. Use the SASB Materiality Finder from International Financial Reporting Standards (IFRS)

In this part of our analysis we use the Materiality Finder to dive deeper on industry and sub sector specific ESG risks that a company may face. The framework is focused on how ESG factors put value creation at risk.

3. Consider the Company’s ability to generate Impact

This section uses multiple frameworks to consider a company’s ability to create positive/negative impacts. We use the UN’s Sustainability Development Goals as a high level framework to consider how the company generates environmental or social impact while contributing to wider society.

Delving deeper, we use the Theory of Change to analyse how the company gets from current operations to desired outcome. To do this we look closely at business operations and the company’s ability to articulate how they create impact.

4. Use the Taskforce on Climate related Financial Disclosures (TCFD)

In this section we assess how the company has considered climate change risks to its physical assets (recognition in the balance sheet), business operations and financial outcomes. We then evaluate the actions the company is taking to mitigate these risks and assess how well placed the company is place to benefit in a net zero future.

5. Modern Slavery

Ellerston Capital conducts a firm wide Modern Slavery assessment of each portfolio using a quantitative framework to assess geographic, sector and business model risks in respect to the Modern Slavery Act which may not cover all companies within the portfolios but is considered best in class.

The EGMS fund then conducts similar Modern Slaver assessments on each of our holdings using both qualitative and quantitative frameworks to assess risks and the validity of any published Modern Slavery statements by the companies.

Q2: Given its increasing prominence, to what extent do you engage with companies and/or the regulator on ESG issues? Can you talk about some recent examples?

The Ellerston Global Mid Small Cap team seek to engage and work closely with portfolio companies at every opportunity. In doing so, the team seek to increase transparency, board composition and articulate any positive environment and social impacts that are relevant to our companies.  An example is outlined below:

Engagement:

WillScot Mobile Mini (‘WillScot’) is the leading provider of modular space and storage units in the United States. It is the trusted leasing partner for a diverse range of customers ranging from construction and industrial end markets to government and healthcare. When you drive by a construction project in the US and see a temporary office on site, odds are one in two would be a WillScot product.

In March 2021 we had a virtual meeting with the company. Our original focus for the engagement was around the company’s timeline to release an inaugural ESG Report. Management communicated they appreciated our interest as not many investors had been engaging them on ESG however it was a real opportunity for the business as fundamentally, the company’s modular units can be refurbished and reused for more than 20 years facilitating circular economy.

Through engagement, we learnt the company was in the development stage of forming an ESG plan, having made key strategic hires. Management also asked us for examples of companies they should benchmark themselves against in forming their ESG roadmap.

Result:

After the call, we provided several examples of stand-out portfolio companies via email, highlighting use of transparent and measurable ESG targets (including linking to UN Sustainable Development Goals) as well as aligning ESG KPIs with executive remuneration and debt financing. Our feedback on ESG best practices was well-received by the CFO, who acknowledged WillScot was still in roadmap development however it was extremely helpful as prioritising ESG focus areas was “a very logical next part of our maturation as a public company”. WillScot now includes an ESG section on its website highlighting its most relevant and material Environmental, Social and Governance risks and opportunities and we look forward to a full ESG report.

Q3: Going forward, how do you see ESG factors evolving in terms of impact on your business and/or the wider industry?

We believe the importance of ESG analysis will only increase across the investment industry. The exponential growth in regulatory support for the Net Zero transition is making ESG risks impossible to ignore for companies and resulting in tangible financial risks for unethical business practices. Our view is that ESG analysis moves away from high level qualitative analysis and shifts to a structural change in how value is considered. ESG and financial analysis will continue to become one in the same.

Q1: Within Pathfinder, what is your philosophy and process towards incorporating ESG factors within your funds?

ESG factors (environmental, social and governance factors) are deeply embedded in our investment decision making.  This tells us what policies and practices a company has in place for interacting with the environment and society, and for governance oversight.

ESG is best described as data points to help assess risk management in a company. Despite what many people expect, ESG data does not provide an ethical lens for assessing a company’s activities.  For us, our values and ethics are a crucial separate layer for assessing which companies we want to invest in.

We believe that companies with high ESG standards are often less risky than companies with low ESG standards. This makes sense – companies with stronger environmental practices are at lower risk of ‘clean up’ costs or brand damage.  Companies that care broadly about society, including employees and customers, will have a more productive workforce and more customer loyalty.  In short, we value ESG factors alongside financial metrics for assessing investments.

Q2: Given its increasing prominence, to what extent do you engage with companies and/or the regulator on ESG issues? Can you talk about some recent examples? 

Shareholders globally are become more engaged as owners in companies.  The first part is voting as a shareholder on ESG issues.  For example, “E” (environmental) votes can include requiring corporate reporting on environmental management (like deforestation or waste impact) and carbon emissions.  “S” (social) factors can include disclosing spending on political lobbying and reporting on human rights standards compliance.  “G” (governance) votes can touch the connection between pay and performance, and appointing independent board members.

In the last year at Pathfinder we voted close to 3,500 times, and don’t hesitate to vote against company management when appropriate.

The second part of engaging with companies is to discuss issues with the board or senior management.  As an example, at Pathfinder this year we’ve engaged with NZX listed companies on issues like the end-of-life disposal of capital equipment, how to define corporate purpose and their approach to climate risk.

Q3: Going forward, how do you see ESG factors evolving in terms of impact on your business and/or the wider industry?

ESG factors will become more and more widely adopted as a way of assessing company risk and for helping drive better investment decisions.  However, the industry will also refine processes over time to enhance data integrity and improve methodologies.

ESG data can throw out some unexpected results, for example many were surprised when S&P recently rated ExxonMobil as higher than Tesla on ESG metrics.  And Dow Jones scores British American Tobacco highly, which to many people is startling.   However, what we will see in future is investors better understanding that ESG investing is not a ‘values overlay’ or moral stance on company activities.  Investors separately need to look at the ethical investment principles a manager adopts on top of its ESG process.

Q1: Within the Foundation Series Funds, what is your philosophy and process towards incorporating ESG factors within your funds?

Our starting point for creating the Foundation Series Balanced and Growth Funds was because Simplicity wasn’t keen to let us promote their funds, and we knew from listening to our investors that there was demand for low cost diversified funds – so we listened, and built what we think are better versions of what they (Simplicity) are doing.

Within the Foundation Series Balanced and Growth Funds our aim is to design our funds in an efficient manner so that it maximises the chances of investors achieving their investment goals.  In constructing and managing these two Funds we focused on balancing building robust diversified investment funds that also minimised overall costs, by which we mean having low investment management fees coupled with also being tax effective. This approach meant that we predominantly put these cost and tax considerations ahead of taking ESG factors into account. These Funds suit the sort of people who say they care about the environment, but then don’t pay the carbon offset when they fly.

The global fixed interest component of these two Fund’s portfolios is actively managed by PIMCO, who don’t hold tobacco companies, arms manufacturers, cluster munitions makers, or companies who drive 10% of their earnings from pornography, or ones where the core business is the exploration, extraction, or refining of fossil fuels. While we think it is good that PIMCO screens this part of our Funds’ portfolios, the primary reason we use PIMCO is because they have a great track record in terms of adding value in this sector.  We also think there are some real short-comings in terms of simply adopting a passive approach to managing fixed interest assets, so even though a passive solution might be a cheaper approach in terms of fees, it will result in an inferior outcome for our investors.  In selecting PIMCO to manage this part of the portfolio the key consideration was PIMCO’s skills as a fixed interest manager, and the fact they undertook additional screening was simply an added bonus.

The structure of our global share portfolio was based on picking tax efficiency that we get from having the majority of the assets held directly by the underlying NZ PIE fund. This removes the tax slippage associated with using offshore funds like the Vanguard ones that Simplicity invests into for global shares.  This offshore fund is unable to provide any tax credit relating to the non-resident withholding tax on the underlying company dividends.  This is a big factor, as it equates to roughly 0.30% per annum of tax slippage on the global share part of the portfolios, which can be a big hidden cost to investors.

The global share portfolio does screen out things like cluster munitions manufacturers and tobacco, but we definitely wouldn’t say it was managed predominantly with an ESG focus. If there was a screened solution with the same tax efficiency and level of fees, then we would have proceeded with this option, but instead opted to put the ESG considerations aside in favour of a more efficiently constructed solution.

This means that the Foundation Series Balanced and Growth Funds aren’t being managed on an ESG basis, as we decided to put more focus on factors like costs and tax efficiency. If people want ESG factors to be their main focus when it comes to investing, then there are other funds on InvestNow that might be more appropriate for them.  However, if you care about minimising fees and tax to get higher net returns, then the Foundation Balanced and Growth Funds are definitely worth considering.

Q2: Given its increasing prominence, to what extent do you engage with companies and/or the regulator on ESG issues? Can you talk about some recent examples? 

The Foundation Series Balanced and Growth Funds focus on areas like low fees and tax efficiency first and foremost.  While there are various screens on the global fixed interest portfolio, our focus wasn’t driven from a starting point of wanting to build ESG funds. The underlying specialist investment managers we use don’t actively engage with companies on ESG issues, reflecting that the global and New Zealand shares are managed on a pure index or passive basis.

Note that if we ever did build a fund that had a big ESG or ethical investment focus then we would think that it would need to be actively managed. This reflects our view that we do not believe simply screening out companies or sectors has a meaningful impact if you are trying to effect positive real-world change.

In terms of these two Funds, we don’t have to engage with the regulator in regards to ESG issues, beyond making sure that the Funds comply with any general regulations and rules in this area. We know that there has been lots of confusion in the industry around the FMA’s guidance around ESG funds (the FMA refers to this area as “Integrated Financial Products”), but given these two Funds are not positioned as ESG funds, we are not captured by this.

Q3: Going forward, how do you see ESG factors evolving in terms of impact on your business and/or the wider industry?

From an industry perspective, it would be great to see low-cost tax efficient passive funds that investors who like the Foundation Series Balanced and Growth Fund  could invest in, that would to also capture ESG considerations. At the moment we don’t readily have access to these types of funds, especially within the global equities asset class, which is why we have adopted a more traditional unscreened exposure in this space.  In the future these types of funds may be something that the Foundation Series can look to bring into the NZ market.