Three Ways to Identify Governance Risk

As more investment professionals acknowledge that responsible investing is coming of age, how environmental, social, and governance (ESG) issues can be incorporated into the investment process has taken on increasing urgency. Among the major questions to consider: Can ESG concerns be aligned with responsible investment practices? Must financial returns be sacrificed in the name of sustainable investing?

 

Sandra Carlisle, head of responsible investment at London-based Newton Investment Management, says that “responsible investment” has nothing to do with nebulous moral considerations — it’s all about generating sustainable financial returns. Carlisle manages the team that integrates ESG issues into Newton’s fundamental research process, and she sees a correlation between company conduct and financial performance.

 

“If a company is doing something they shouldn’t do, share price and credit ratings will eventually respond,” Carlisle told the audience at the 2016 CFA Institute Wealth Management Conference. For a shareholder, “there is nothing more horrifying than learning about something bad you didn’t know about,” she said. Though she did not explicitly acknowledge it, Carlisle’s presentation evoked memories of the Volkswagen emissions scandal, which sent the automaker’s share price plummeting when it came to light in September 2015.

 

Carlisle explained that Newton’s approach to responsible investment focuses on identifying and avoiding risks that would negatively influence investment returns. Its ESG analysis examines elements that could have a material effect on company value, either through reputational or financial loss.

 

As one might expect from a long-term investor, Carlisle maintains that governance is a key point of emphasis. “A company that is not well run — has board members that have been there forever, which pollutes and doesn’t treat employees well, and overpays its senior executives — is not operating with the best interests of shareholders in mind,” she said.

 

Before investing, Newton conducts thorough research to analyze and understand a company on three particular levels:

  • Board of Directors: How is the board composed in terms of diversity, tenure, and independence?

  • History: Does the company have a track record of environmental carelessness or infractions?

  • Culture: How does the firm engage with the community and exercise stewardship over shareholder resources?

Examining a company in this way can help identify problem areas as well as the potential for future investment losses.

 

The recent tribulations of Zenefits, a San Francisco start-up operating in the health insurance and human resources space, demonstrate how analyzing a firm’s culture can help identify potential red flags. Earlier this year, Zenefits’s replacement CEO announced that the company suffered from issues with its culture and tone, writing that “our internal processes, controls and actions around compliance have been inadequate.” One month later, Fidelity announced that it was marking down its investment stake in the company.

 

As a shareholder, Carlisle’s firm wants to stay invested for the long term — its average holding period is three to five years — so its approach to responsible investing is a risk-management-oriented process designed to avoid mistakes that would force it to exit a position prematurely.

Identifying and avoiding bad actors can help align ESG considerations by bridging the gap between values-based investing and the prudent exercise of fiduciary duty.

 

“A values-based approach to investing is legitimate for the client, but not for the manager,” Carlisle said. As a fiduciary, however, “once you’ve identified something as a risk, you have no choice but to look at it.”

 

All posts are the opinion of the author. As such, they should not be construed as investment advice, nor do the opinions expressed necessarily reflect the views of CFA Institute or the author’s employer.

 

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