Active Involvement by Fund managers helps overall valuation

Active Involvement by Fund managers helps overall valuation

With the ferrous competition in the financial industry within India and overseas, Investment as with many other products that need to be sold to customers, is about marketing and branding. Find the right catchword or slogan and the brand might catch on. There by giving a USP there by creating a niche product which help selling it to new customers or existing customers as a product that is different there adding to their portfolio and helping the financial institution make the sale.  this is not just about appearance the search for an effective re branding might also reveal the critical change to a product that will give it appeal and deliver value to customers.

The field of what was once known as “ethical” investing may be at the early stages of a makeover. Once thought of as a form of risk mitigation nobody wants to own the company that commits the next big scandal, ethical investing has become an attempt to generate a superior return. In its old form, as a screen to exclude the sin sectors such as tobacco and alcohol, it signally failed.  Excluding the sin stocks merely made them cheaper for those with fewer scruples, and the net result was that ethical funds underperformed.

But ethical investing has since been superseded by periods of SRI (socially responsible investing), ESG (environmental, social and governance) and sustainable investing and the latest term “engagement”.

From a marketing point of view, there is nothing much wrong with ESG at present. The amount of institutional money managed according to some kind of environmental or social mandate is continually growing, and they funds are    actually making money. Companies that show up with good sustainability practices, for example, tend to outperform in the long run.

World over many large institutions and some of them even in India in the last couple of years have been speeding time and money in building up their ESG practices. ESG is seen as a defense of the active management industry against passive investing, although it has also become a focus of indexing groups. All the main indexing groups have a suite of indices that purports to capture ESG factors best. In this way it is being treated almost as a smart beta risk factor that can generate returns and take advantage of a market anomaly, such as value or momentum.

A focus on engagement could rescue ESG as a form of truly active management. The hope is that it will be a strategy that makes money for savers while helping to improve the world into which they will eventually retire and that their descendants will have to inhabit. Due to the ultra-low and negative interest rate regime that the world is witnessing at present.

The argument in favor of intervening with companies is that if you can persuade a company to behave in a way that is more appealing to investors then the price will go up, there by yielding a better overall return and creating the alpha in the portfolio.  Those who engage with companies have an opportunity for superior returns. Those who ignore companies and veto them will be too late to the party and could lose out on the relative out performance.

Anecdotal research with data from large institutional investors showed that a marked out performance by stocks it held, once the investor had successfully intervened on an environmental or social issue, such as reducing carbon emissions targets. There was no downside if the engagement was unsuccessful, the company merely tracked the index there by showing that probability of creating the alpha was significantly higher.  Significantly, there were no such clear cut returns after engagements on corporate governance issues.

This shows a difference between engagement and activism, where investors take stakes in a company and then enter into often aggressively hostile fights with the board. This demanding approach is far less likely to work in emerging markets, where many companies are still controlled by their founding families and where local regulations are often unhelpful to minority investors.

There is a lot of value add that a private equity investor does to a company, one of the significant ones is the one on engagement on such issues there by adding a premium to the valuation and helping the founders make a good exit price.

With active fund managers seeing the advantage of the additional return that the overall market gives for active involvement, increasing number of fund managers on Wall street as well as Dalal street are interested in active improvement with companies.

_ Farzan Ghadially