Active managers must look beyond ESG ratings to add value over passive sustainable funds, says Zadig
A revamp of the Oyster Sustainable Europe fund was announced in June, with European equities specialist Zadig Asset Management being brought in to manage the portfolio.
Sustainable investment funds like Oyster Sustainable Europe are attracting substantial inflows as big institutional investors increasingly look to increase their allocations towards ESG and impact-oriented portfolios.
Research from CoreData shows that over half of global institutional investors now fully integrate ESG into their investment approaches, up from 36 per cent in the last quarter of 2019.
Co-heads of investment strategy for the Oyster Sustainable Europe fund, Adrian Vlad and Louis Larere, say their aim is to “do sustainability at a reasonable price”. The two have been running their sustainable, responsible, and impact investing (SRI) strategy on a model portfolio since March 2019.
The fund keeps a very concentrated portfolio of up to 25 names at a time, which seek to be 20 per cent more sustainable than the market at large.
“For ESG investing, you can build a portfolio where you simply take the highest ESG rating scores and you build a portfolio out of that, and that's enough. You can do that passively. You don't need an active manager,” says Adrian Vlad.
Instead of screening for stocks with high ESG scores from the ratings agencies, like a classic ESG fund, Vlad and Larere believe sustainable investing requires a more active approach.
“We looked at that long and hard and we thought, this doesn't make sense,” says Vlad. “The value-add of an active manager is to dig for those companies that are more sustainable than the market gives them credit for.”
Vlad says he has spoken with a “big German pension company”, whose policy is to only invest in funds that are in the top quartile for ESG ratings. “An approach like that is very simple, but for us, it misses the bigger point of sustainability, which is your purpose as a company, and the goods and services that you provide.”
Larere adds that there are “already plenty of ETFs” that track rankings by ESG data providers. “But when we look at what's inside those ETFs, it's nothing like what we would do at all.”
Passive investing may soon swallow up a larger chunk of institutional ESG allocations. Pension funds, mutual funds and insurance companies with ESG exposure currently allocate only one fifth of these budgets to passive funds, according to a survey of European institutional investors by Invesco, but almost half say they plan to increase the amount they invest in ESG ETFs over the next two years.
These ratings-focused strategies also mean that prices get bid up for highest rated companies, such that “pure sustainable companies” such as the Danish green energy company Ørsted command very high valuations.
Vlad and Larere prefer instead to find “hidden gems”, such as Dutch firm Aalberts, which specialises in piping systems that increase the energy efficiency of buildings, but is not widely covered by analysts. “Nobody's looking at it because it is a core construction company, but they have an interesting sustainability story, which is just not being talked about,” says Vlad.
Another set of companies that are often invisible in ESG ratings are those that currently invest 10 or 20 per cent in sustainable goods and services, but have a plan to get to 40 or even 50 per cent in a few years’ time.
Larere explains: “Any rating, whether ESG or sustainability exposure, is always looking at the spot situation and is never providing forecast of where this is going to evolve. This is really our job, as analysts first and hopefully as managers, to look at where companies are going to be in three, five, and 10 years’ time.”
Larere gives French car parts supplier Valeo as an example. Valeo has invested heavily in the past few years in a joint venture with Siemens to develop the means to build and maintain electric vehicles, but has so far harvested little in the way of revenues. “Consumption is very low because hybrid and electric cars are a small market today, but we think in the next three to five years, it's going to grow quite a lot.”
He says the stock is “probably going to be a long-term holding” as the auto market will take a while to recover from the hit to sales from Covid-19. Ratings provider S&P predicts unit sales will fall by up to 25 per cent in Europe for the full-year.
The average holding period for the fund is between 12 and 15 months, so while they don’t play quarterly earnings, they also try not to “get into positions and then sleep on them”. Larere and
Vlad notes that ideal investments are in companies they have followed for a while, but which are suffering from some controversy in the market or a valuation gap that tilts risk and reward in their favour.
The team has a “zero tolerance” policy on owning oil and gas, tobacco, weapons, gambling, alcohol, and mining companies, and a “low tolerance” for firms in industries like utilities, which often rely on fossil fuels. In order for them to invest, these low tolerance companies must not exceed the “limit of 30 per cent of the business exposed to fossil fuels”.
Larere and Vlad do not rule out oil and gas companies one day joining the “low tolerance” category if firms speed up a transition to renewable energy.
The Oyster Sustainable Europe fund gave a total return of 4.6 per cent in July.