Many investors like the idea of investing in line with their principles – why would they support companies with their pension contributions that they wouldn’t support with purchases during their weekly shopping? However, there remains a lingering fear that if people invest according to their conscience, it is liable to reduce the returns they receive. That view looks increasingly antiquated, however, as the responsible investing sector matures.
Until the past decade, responsible investing was at best an inexact science, often more of an art. Companies rarely if ever published sufficient information to facilitate analysis of factors such as carbon emissions, gender pay equality or biodiversity impact. Investors who wanted to act responsibly were largely obliged to exclude sectors such as tobacco, gambling or arms manufacture, and, increasingly, fossil fuels. As these were often defensive sectors considered more resilient in times of economic or financial turbulence, ethical investing became associated with higher risk.
This perception is increasingly being challenged as responsible investing enters the mainstream. Regulatory changes such as the European Union’s Sustainable Finance Disclosure Regulation (SFDR) and its future Corporate Sustainability Reporting Directive will require financial institutions and other companies to disclose far more data on their environmental and social impact, giving investors the information they need to make more informed choices.
Investors seeking to make an impact aren’t necessarily confined to start-ups and other smaller, risker businesses.
Already the emergence of global concern about climate change has prompted the growth of companies that seek to provide solutions or mitigation. Renewable energy companies, for example, are now often large, mature businesses with recurring revenues and sound cashflows – so investors seeking to make an impact aren’t necessarily confined to start-ups and other smaller, risker businesses.
Diversity of responsible investment
As the demand for responsible investment has grown, it has prompted investment management groups to launch new products, or to upgrade or redefine existing ones. Today more than half of the European fund universe is categorised under article 8 or article 9 of the SFDR, according to Morningstar, holding assets totalling close to €5 trillion. Article 8 (“light green”) funds “promote environmental or social features”, while Article 9 (“dark green”) funds are “environmentally sustainable investments”.
The aim of the legislation is to give investors greater clarity and consistency on the approach of asset managers to environmental and social issues, although fully achieving this goal will take some time because there is still confusion about how the rules should apply, as well as significant gaps in the underlying corporate sustainability data.
There are now a range of approaches. An ESG (environmental, social impact and governance) overlay is now standard at many fund groups. This is more of a risk management tool, and seeks to ensure that companies are not on the wrong side of environmental or social change, or – where there are problems – that they are taking action to mitigate those risks. Fund groups will often engage with companies to encourage them to address problem areas, such as carbon emissions or supply chain human rights abuses.
This approach can give fund groups freedom to invest in sectors such as fossil fuels, or in theory even tobacco, as long as companies are taking action to address the risks they face or transition to sustainable business models. They may invest in oil companies that have set out a blueprint for switching focus to renewables, or a chemicals company that has plans to recycle or reuse its hazardous waste.
However, more purist approaches are gaining popularity. Funds that claim to have a sustainability purpose beyond delivering an investment return that fall under article 9 of the SFDR look to create a positive impact through their investments. Rather than simply avoiding doing harm, they target companies that are actively contributing to change, whether through developing carbon capture technology, building renewable energy infrastructure or distributing software to improve energy efficiencies.
The breadth of possible investment strategies means that the investment performance of responsible funds can and does vary widely.
The breadth of possible investment strategies means that the investment performance of responsible funds can and does vary widely. The assets held by an ESG fund may be little different from those of a traditional fund (for instance, they may hold a large proportion of technology stocks because the underlying companies have low carbon emissions), whereas impact funds may focus on innovative companies that enjoy higher growth at certain points of the economic cycle but struggle at others.
The past few years have shown the variability of different approaches. In 2020 and 2021, there was enormous excitement among investors about the possibilities offered by the transition to clean energy, with the share price of companies that appeared to be offering solutions soaring. This was reflected in the performance of funds such as the iShares Global Clean Energy ETF, whose value almost tripled between April 2020 and January 2021. However, performance weakened during 2021 as the Ukraine war reignited demand for fossil fuels.
The strength of traditional energy companies created difficulties for the purer responsible funds in 2022. Belatedly, investors recognised that the energy shortage was ultimately likely to accelerate the adoption of renewable sources, but in many cases such companies shed high valuations.
There are always likely to be dilemmas arising from investing responsibly.
Responsible investing trade-offs
There are always likely to be dilemmas arising from investing responsibly. For example, if an investor excludes sectors such as traditional energy or utility companies, it becomes more difficult to build a portfolio delivering an income stream because these have historically paid substantial dividends. The greater the impact an investor seeks to create with their investments, the more they are likely to gravitate to smaller companies, growth stocks, embedding style biases to traditional equity indices. There will be times in the market cycle when this option bears fruit and others when it does not, but investors have to assess the impact on their overall portfolio and on their personal investment goals.
Investing responsibly can introduce sector biases to a portfolio that can impact performance in different market climates. However, there is a wider question as to whether companies that manage their environmental, social impact and governance risks effectively enjoy stronger share price performance than those that do not. Intuitively, it feels right that a company with stronger risk controls should perform better, but not necessarily across all timeframes.
Intuitively, it feels right that a company with stronger risk controls should perform better, but not necessarily across all timeframes.
A recent report into the impact of ESG factors on share price performance by US institutional investment manager Federated Hermes found a clear link between social impact and governance considerations and higher share prices. The link between environmental factors and share prices is weaker, but appears to have been increasing over the past two years. This maps to growing transparency requirements that risk reputational damage for companies accused of damaging the environment.
In theory, as more investors such as pension funds demand that companies manage their ESG risks effectively, the fewer buyers there will be for the shares of companies that do not comply, putting their share prices under pressure. But alternatively it could simply encourage them to go private.
Investors should not set out from the principle that they must sacrifice profit for principles, or vice versa. The market for responsible investment is now sufficiently diverse that investors have a much greater ability to match sustainable funds or individual assets to their risk appetite and financial goals. However, they must accept that, as with all investment, performance is liable to vary according to the changing market environment, whichever flavour of responsible investment they choose.