As always, I think that examples help understanding.
ESG – the inputs
ESG stands for Environmental Social and Governance factors. There are endless examples that we can now all point to which illustrate how these are critical for all investors to understand, not just in terms of new opportunities but also risks.
The environment is arguably one of the key reasons why Tesla is now worth more than Toyota. This is a key part of the global economy and the Paris Agreement has seen governments publicly commit trillions of dollars to this space.
Social factors were recently thrust into the spotlight when Boohoo’s share price tanked after accusations of modern slavery in its supply chains.
And governance is critical – remember Enron? Wirecard? Philip Green?
If we think of investment funds as products, ESG are inputs into the machine. Inputs which help decision makers to work out the rewards and risks in any investment opportunity, from real estate, to bonds to shares.
Sustainable – the output
Having used the ESG toolkit, fund managers can then decide how to manage money in their fund range.
Some will run so-called “Ethical Funds” – funds which actively screen out ‘nasties’ such as arms, tobacco and pornography. In the past these were associated with lower returns as investors missed out on what were large returns from oil and tobacco firms. The initial driver for these funds was often a home for church money, reluctant to fund controversial ‘unethical’ activities. There continues to be a demand for these products.
More recently sustainable funds have soared in popularity. Flows into sustainable funds were more than $21 billion in 2019, a nearly fourfold increase over the previous calendar-year record, which had been set in 2018.
These are typically thematic funds – funds which focus on green energy, carbon-neutral, water and the like. They resonate with people who like the sense that they can both do well and do good, using their money to help create a better world.
The trouble is that it’s very hard for most of us to get a clear sense of just how sustainable these products are. For example, only 10% of sustainable diversified equity funds are fossil-fuel-free. We quickly enter into the realm of very complex debate on how best to influence change – is it by being a large shareholder, having a seat at the table and working with firms to lead and influence change? Or do some ‘baddies’ only understand the kick up the arse approach?
As for another label, ‘impact investing’ is still relatively small today – the burdens of proof are much higher and so the investible universe is smaller. As flows grow, opportunities and reporting develop and the world evolves, this sector will likely grow much faster.
There is now more data than ever about the relative outperformance of sustainable funds. The following chart from Morningstar shows how sustainable funds did against their traditional peers over a three and a five year timeframe.
Over 3 years, 40% of sustainable funds were in the top quarter of funds in their category (eg large cap equity). Over 5 years – although the number of sustainable funds with a track record this long falls to only 90 – nearly a third of sustainable funds were top quartile.
Whichever way you look at this, the old urban myth that sustainable impacts returns is not accurate. And track records suggest this is a longer-term truth than simply a very short-term Covid-19 response to depressed demand for oil.
Ch... ch... ch... changes
We all have different motivations. And we all juggle the tension between financial returns and ‘doing the right thing’. Do you buy the free-range chicken when no-one is looking – or not?
All of our research confirms that investors increasingly care about their financial clout when it comes to helping change– 74% of advised customers told us that they would value a conversation about this with their adviser, although advisers felt that just 30% of their clients would be interested.
We now see ESG inputs acting to serve both those who want to save the planet AND those who want to make better returns and avoid corporate blow-ups. With the momentum underway, the focus is now on investment firms to tell advisers, investors and pension holders a much clearer story on what they actually hold. And how sustainable that sustainable thing actually is!?
Once we know that, it’s up to us how we vote with our feet.
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