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ESG exclusions no barrier to healthy returns, says MSIM’s Bruno Paulson

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Morgan Stanley’s Global Sustain shows that even with a wide array of exclusions, an ESG fund can generate decent returns. Jan Wagner asks Global Sustain’s manager Bruno Paulson (pictured) how he achieved this and how the sustainable investment process at Morgan Stanley Investment Management works…

Morgan Stanley’s Global Sustain shows that even with a wide array of exclusions, an ESG fund can generate decent returns. Jan Wagner asks Global Sustain’s manager Bruno Paulson (pictured) how he achieved this and how the sustainable investment process at Morgan Stanley Investment Management works…

It’s generally assumed in asset management that if you limit your options, you could wind up sacrificing return. This makes intuitive sense and is why managers doing sustainable investing have tended to keep exclusions of sectors to a minimum and instead focus on promoting adherence to environmental, social and governance (ESG) criteria among the companies they buy. In the latter case, managers work with what they have – that is encourage adherence through engagement with investees as well as overweighting or underweighting them according to their ESG efforts.

However, the Global Sustain Fund from Morgan Stanley Investment Management (MSIM) seems to be challenging the assumption about limiting your options. Despite a wide array of sector exclusions – and not just controversial ones like gambling, adult entertainment and firearms, but also more mundane ones like fossil fuels and utilities – Global Sustain has outperformed the market since inception in last June 2018. As of last 30 September, Global Sustain’s concentrated stock portfolio had gained 10.8 per cent compared with around four per cent for its benchmark, the MSCI World. The fund’s performance is less the management fee of 1.5 per cent annually, but not less sales fees, which can run as high as 5.75 per cent.

Global Sustain, marketed in Europe as an ESG fund that is ‘strong on engagement and light on carbon’, has also had strong inflows. In the fifteen months since inception, the fund has taken in USD235 million. Around half of those assets are from institutional investors, including, according to a news report, the GBP711 million Scottish Borders Council Pension Fund. The other half of the inflows come from private clients who are typically served by a wealth manager. The fund’s sales fees are particularly relevant for this latter group.

Interestingly, Global Sustain’s manager Bruno Paulson says the fund’s impressive start has had less to do with the international equity team excluding anything for ethical reasons and more to do with the investment strategy implemented by the team. 

“We’re not taking a moral stance here, but instead looking for companies that have strong intangible assets like prominent brands and pricing power,” says Paulson. “Such companies offer high returns on operating capital (ROOC) and recurring revenue, which means that in a downturn, earnings don’t go away.”

As a result, Global Sustain not only avoids controversial sectors, but also steers clear of banks, energy companies and miners, because, as Paulson says, “these are businesses which are cyclical and which can offer a low return on capital.” He cites the example of utilities, which have an ROOC of just seven per cent. This compares with an ROOC of between 50 and 60 per cent for the Global Sustain portfolio.
  
So what are the 36 companies – Paulson calls them “compounders” – in the portfolio? They include information technology firms like SAP, Microsoft and Google parent Alphabet; health care suppliers like Baxter and Medtronic; as well as consumer goods firms like Unilever and Henkel. Indeed, these three sectors make up more than 80 per cent of the fund. In geographical terms, US stocks account for 61 per cent of the fund, followed by those in the UK (18 per cent) and Germany (around ten per cent). Global Sustain is almost fully invested, with just two per cent held in cash. 

Paulson notes that Global Sustain’s portfolio largely resembles that of MSIM’s flagship Global Brands Fund, as both funds follow the same strategy. Launched in October 2000, Global Brands has grown to USD14 billion and as of last August, had bettered the MSCI Word by eight percentage points This performance is, again, exclusive of sales fees. 

Says Paulson: “The point about Global Sustain is to satisfy those clients who say we like what you do but we don’t like alcohol, tobacco or carbon-intensive sectors. We’re looking to deliver a focus on compounders to an audience, namely ESG-minded investors, that might otherwise be excluded from this strategy.” 

Judging both by its wide-ranging exclusions and its emphasis on engagement, Global Sustain should satisfy even the most demanding ESG-minded investors. According to Paulson, MSIM’s international equity team is made up of eleven analysts/portfolio managers. It includes Vladimir Demine, who last February was appointed to the role of head of ESG research. For the team, the ESG issues and risks vary according to the sector. Therefore, while it relies on ESG data from external suppliers, it does not use a standard scoring model. 

“With, say, a consumer goods company, we want to know where they are with issues such as animal testing, palm oil or use of plastics,” Paulson says. “If you’re talking about one of the software or IT service providers we hold, then it’s all about the data. We want to know how secure the data is and the extent to which external parties have access to such data.” 

Moreover, for all companies in the portfolio, the MSIM ESG team engages on executive compensation to guard against excesses.

Regarding the economic outlook, Paulson agrees that there are clear signs of a slowdown – though he adds that he is less concerned given Global Sustain’s robust portfolio. “A downturn will happen, but I can’t tell you when. But because we’re not people who see the glass as half full, we’ve been preparing for it,” he says. “And we have done that by choosing companies that we believe can withstand a downturn due to their ability to compound.”

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