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Good governance

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7 August 2020

David Prosser discusses ESG and the crucial role investment company non-executive directors play.

It is becoming fashionable amongst those looking for a stick with which to beat investment companies to bemoan the sector’s supposed failure to embrace environmental, sustainable and governance (ESG) principles. One report earlier this year complained investment companies account for only a meagre portion of ESG funds compared to their open-ended counterparts, even though they actually punch above their weight if you consider the total numbers of both vehicles. Another pointed to the difficulty of identifying investment companies that take sustainability factors into account during the investment process.

No doubt there are improvements that can be made. New European Union regulation due to come into effect next year will require all funds to disclose how they consider sustainability risk in investment decisions, which should promote transparency across the board. And given the weight of money pouring into ESG investment styles worldwide, there are likely to be new issues in the closed-ended sector once market conditions begin to normalise.

It’s worth pointing out, in any case, that investment companies have pioneered the development of collective investment funds offering exposure to sectors such as renewable energy. These vehicles may not be marketed as ESG products, but their portfolios certainly stand up to scrutiny.

However, there is also a broader point to consider here. Discussions about ESG investing often focus on environmental and sustainable criteria. The idea of a fund that invests in, say, green energy or the circular economy, is easy to get a handle on, with tangible examples of what might be in or out. Governance, by contrast, is a more nebulous concept – we can often point to examples of bad governance after the event, but defining what is good and a framework for studying it can prove more challenging.

In this regard, investment companies have an important advantage. The investment company model, in itself, offers a shining beacon of good governance in a global fund management industry that is dedicated to selling trillions of dollars’ worth of product to savers and investors. With an independent board that has fiduciary responsibilities to shareholders, well-run investment companies recognise they exist to serve the interests of its investors, rather than to deliver profitable margin to a fund manager.

High-profile examples of that principle playing out in practice crop up week-in and week-out. In recent days, for example, we have seen the announcement of a merger between Perpetual Income & Growth and Murray Income Trust; the deal follows the former fund’s decision to let go its previous investment manager, Invesco, after a run of underperformance. Elsewhere, we have just seen Baillie Gifford awarded the contract to run Witan Pacific Investment Trust, one of the industry’s best-known Asia specialists, whose board is seeking to improve performance for shareholders.

These are often difficult and uncomfortable situations, but when investment company boards show their independence in this way, they underline the value of the sector’s governance model. They provide tangible examples of what good corporate governance looks like.

It’s an important issue. As ESG investment styles continue to grow in popularity, fund managers will want to offer more vehicles that give investors what they’re looking for. But managers should also be practising what they preach. It’s one thing selecting or rejecting stocks on the basis of ESG principles; it’s quite another to observe those principles yourself.

It is not necessary to be an ethical or socially responsible investor to see the merits of this approach. One reason why ESG styles are coming to the fore is that irrespective of their own values, investors increasingly see the link between good ESG practices at businesses and long-term outperformance. This is why so many fund managers now consider ESG factors in stock selection, even if they are running funds with no official ESG agenda.

In which case, it surely makes sense for investors to take exactly the same approach. Whether or not ESG values matter to them, it would be wise to pick the managers – and the investment funds – that embrace such principles. Investment companies, on governance at least, have been doing that for years.