ESG funds appear to have passed the volatility test in recent months, but what will the next generation of sustainable funds look like? Mark Dunne reports.
Green is the new gold. There was a time that investors ditched growth assets in favour of precious metals when the world caught a bad dose of economic uncertainty. Now it seems that the strategies adopted in such challenging conditions are changing.
With the world facing a deep economic downgrade, investors are running to the safety of gold, judging by the seven-year peak in its value during the pandemic. Yet what is surprising is that investors are also moving into certain equity funds.
They have dumped traditional funds, as expected, but are moving some of their cash into sustainable strategies, which seek to not only achieve a financial return but also make positive environmental and social impacts.
These funds, which are also labelled ESG or SRI (socially responsible investing), typically focus on particular strategies, such as low carbon exposure or supporting companies that have diverse management teams. They can also exclude companies from their list of holdings which, for example, make and sell alcohol, cigarettes, weapons or are involved in gambling.
Indeed, in the first quarter sustainable funds in Europe reported inflows of €30bn (£27bn), according to Morningstar. At the same time investors pulled €148bn (£133.5bn) from Europe’s wider fund universe.
Marketing departments supporting fund managers have been telling investors for years that sustainable funds offer downside protection. This sales pitch was put to the test towards the end of 2018. After years of relative calm, the outbreak of a trade war between US president Donald Trump and his counterpart in China, Xi Jinping, gave the markets their first real turbulence since the credit crunch. “Many sustainable strategies were resilient during that period, just as they have been so far this year,” says Oliver MacArthur, senior consultant at Aon.
Indeed, more than half of ESG funds have made stronger gains than their traditional counterparts in the past 10 years, according to research into the performance of more than 700 such funds in Europe.
Even the heaviest dose of volatility to hit the markets in 12 years could not disprove the theory that sustainable strategies perform better in falling markets. SRI funds in the UK All Companies sector posted a 21.8% loss in the three months to 20 April, while the wider UK All Companies sector lost 25.6% over the same period. SRI funds even outperformed the FTSE All Share, which dipped by 24%.
From an international perspective, SRI Global funds dropped 10.8%. This compares to falls of 13.7% in mainstream global funds and 13.5% by the MSCI World index.
“It was not a surprise to me that sustainable strategies have outperformed so far this year, but the magnitude of the outperformance over the first quarter was quite startling, in a positive way,” MacArthur says.
Indeed, Margaret Childe, head of ESG Canada at Manulife Investment Management, is also seeing evidence of positive performance by ESG indices compared to regular benchmarks and notes the continued inflows into ESG funds that are performing well. “Although the S&P500 was 11% down we saw ESG funds with that benchmark outperform,” she says.
Childe adds that Manulife provides ESG integration to all its clients as they believe it provides a fuller risk-return profile. “We have seen benefits of that approach going into the pandemic and the market turmoil that followed, which puts our managers in a good position,” she adds.
Newton Investment Management’s sustainable strategies are also performing positively against their peers and benchmarks. Its Sustainable Global Equity strategy, for instance, had a good period going into the crisis and has been holding up quite well in the recovery, comfortably outperforming the S&P500.
It is a similar story for Peter Walsh, head of Robeco UK, who says that the sustainable versions of the asset manager’s strategies have generally performed better than the standard versions across most asset classes. He points to half of the returns from Robeco’s credit strategies have been attributed to using Sustainable Development Goal screenings when picking stocks.
“We do not have a non-sustainable version of our global equity strategy to compare to, as our strategy fully integrates sustainability inside. Performance year to date is +2%, while the market was down around 7%,” he adds. “That tells us that sustainability is delivering, it is driving returns.
“In emerging market equities our sustainable version is doing about 4% better than the standard versions in the year to date,” Walsh says. “Across credit, global and emerging market equities, there seems to be a consistent outperformance of the sustainable versions of our strategies.”
A look at the performance of such funds and their inflows during the pandemic could be taken as a sign that attitudes are changing.
“The question of does ESG and sustainable investing lose you money is largely, even in the US, no longer being asked. The past five years have shown that funds labelled ESG or sustainable have done pretty well,” says Andrew Parry, head of sustainable investment at Newton Investment Management. “The question is changing from why should you consider ESG to why wouldn’t you,” he adds.
Another asset manager hopes that the performance in the first half of the year will continue to change opinion about ESG investing.
“There is a perception, which is probably wrong, that sustainability costs performance. It doesn’t and if it doesn’t, then you should do it,” Walsh says.
Low on oil
“Sustainable strategies historically have tended to be more resilient,” MacArthur says. “They protect on the downside.
“In terms of magnitude, the pandemic is the most significant test of ESG since the credit crisis,” MacArthur says.
Yet could part of the reason for sustainable funds withstanding this test be down to weak energy stocks? The price of oil did fall into negative territory for the first time in the first quarter and ESG funds are unlikely to have a meaningful exposure to oil and gas companies as traditional equity funds and FTSE100 trackers would.
Fred Isleib, director USA, ESG research and integration at Manulife Investment Management, says that the market has seen a sharp recovery and sustainable funds in an upcycle like this tend to underperform while lower quality names may outperform, but believes that this could be short term. “It will be interesting to see at the end of the year, through this pandemic, how these sustainable funds perform.”
The early signs are good, believes Aon’s MacArthur. “Sustainable strategies also kept up with the recovery since early April,” he adds. “It has been an encouraging period, year to date.”
Parry believes that the strong performance recently is down to stock picking and not excluding oil and gas entirely, as the strategy has a minor exposure to carbon emitters. “The ones we do own are in transition and are working to get rid of coal from their operations, but it has been advantageous for us not to hold the big oil and gas companies.
“We see sustainable considerations as a tool for effective stock picking,” he adds. “It has been additive and has come through its test quite well.”
But sustainable strategies are not completely immune to market conditions as they do have an Achilles heel. “If we see a rally in cyclical stocks towards the end of the year or a upward repricing of interest rate expectations, such funds could be vulnerable, but the shape of the market environment year to date it has been constructive for these strategies,” MacArthur says
Interest in ESG strategies is as strong in Europe and the UK today as it has always been, MacArthur says. Yet he has witnessed a new trend in the past two months of US investors taking an interest.
Newton has a US sustainable strategy managed in London that is seeing client interest in America. “That has been our biggest area of inflows,” Parry says.
Newton is not just welcoming new clients but is also seeing existing investors within the business switching to more sustainable versions of its core fund range such as its global real return, global equity and global dynamic bond strategies, Parry says. “That is the biggest change we have seen in the past few years.
“They have seen the performance, they have seen that switching into the sustainable equivalent doesn’t come with a penalty, and there is this growing desire by pension funds, charities and private wealth investors to match their values to their investment purpose,” he adds.
It is not just an increase in interest that Walsh is seeing, but also a change in what people are talking about when it comes to ESG.
“The attention is heightened,” Walsh says. “Everyone is looking at ESG now, digging deeper to understand the contribution it makes and what difference it has made during the first few months of this year.
“Across the board, there has been an uptick in appetite to integrate sustainability into investment strategies,” he adds.
“From a conversation perspective, there is definitely more of a focus around the S,” Walsh says. “To be honest, carbon reduction is still the primary driver of peoples’ focus. The S is more interesting, but there are regulatory elements around the E and it is so tangible.”
Part of the reason behind the growing interest in integrating sustainability into investment decisions could be political will. Governments around the world face huge bills to meeting sustainability targets, such as keeping temperature rises to a maximum of two-degrees, which is at the heart of the Paris Agreement.
They cannot fund this transition alone and so have been encouraging private capital to assist, through setting climate and social development goals.
Growing interest in ESG funds could also be due to rising awareness of the need to build a more sustainable future. The “we only have one planet” mantra could be working.
“Investors are not just seeking portfolio returns, but also returns for people and the planet,” MacArthur says. “It is not just about financial returns anymore. It is about future proofing portfolios with the intention to deliver long-term risk-adjusted returns. With the macro factors it paints a picture for increased demand going forward.”
ESG funds: the next generation
MacArthur says that the climate narrative is evolving for passive investors with more sophisticated, forward-looking indices emerging. Concepts such as climate transition risk, tilts towards renewable energy and net-zero indices appeal directly to investors’ sustainable ambitions.
The climate-focused passive investment market has come a long way in the past decade. The first such indices were focused on carbon and fossil fuels. It was a much broader approach to the issue.
The active ESG space has also changed. More and more funds that help investors meet environmental and social challenges are now using the UN’s Sustainable Development Goals to target their investments. They are investing in companies that the managers believe are aligned to at least one of the 17 goals.
Childe says that ESG is not a new concept, but how investors approach it will continue to change. “We will continue to see an evolution in the approach to ESG and sustainability, I anticipate we will see more focus on achieving positive social and environmental outcomes from a portfolio across public and private markets,” she adds.
Isleib adds that the S in ESG is going to become more popular with investors.
“The social movement is going to pick up steam.”
“In the past few years, for sustainable funds the focus on the environment was paramount, but as a result of the pandemic and the equality issues that are going on, this is leading more to a focus on social, towards employees, towards diversity.
“Ultimately, these issues are intertwined,” he adds. “We are not going to focus on just one of them.”
Despite the sustainable investment fund universe evolving to include a wider range of factors, the man-made threat to the environment will not disappear from investors’ list of goals. “The climate narrative is here to stay,” MacArthur says.
Building better funds
ESG is a broad church and with so many environmental, social and governance issues to consider, how can managers build pure ESG funds. If they invest in a company because it is using less water in its operations and cutting its level of harmful gas emissions, it may be failing to ensure safe working practices for its staff in one of their subsidiaries in Asia.
“Funds that have ESG integration can be created, but the purity question is the real challenge because it is tricky. There are shades of grey at a corporate level,” MacArthur says.
Part of the issue here is that the product and services businesses offer changes over time, as does how companies conduct their business. “It is those changes in dynamics at the corporate level which are juxtaposed against changes in the sustainability narrative and market concepts,” MacArthur adds.
“Who was talking about privacy issues in technology five to seven years ago? It is front and centre today.
“The changing concept of what is material in the sector and changing corporate dynamics makes it tricky to create a pure ESG fund. “It is tricky because no company is perfect and perhaps no fund will be,” MacArthur says. “That is not to say that incorporating ESG factors cannot be achieved.”
Whether or not asset managers can build a pure ESG fund has become something of a philosophical debate.
“Pure is an interesting term. If you tried to apply a test of purity you would not own any company,” Parry says. “The problem is that society overall is in an environmental deficit. We will use up an entire year of Earth’s resources by 1 August.
“Given the events we are seeing around the world with the human cost of Covid-19 and Black Lives Matter, we are also in a social deficit. “Then you have the definitional problem of what ESG is. We don’t label any of our product ESG; ESG is an input not a label. We regard it as Finance 101,” he adds.
For Parry, there is no universal definition of what is and is not suitable for a sustainable fund, which is part of the problem. This is a case of not being able to please everyone.
“Taking a moralistic viewpoint is dangerous,” Parry says. “It’s not our job to impose our values on client portfolios, as while we all have values, they differ from person-to-person. One person’s morals can be another person’s good night out.”
Childe says that there are many views on what constitutes a pure ESG fund. “At Manulife we have put a lot of thought into it,” she adds. “We are looking at how we can provide differentiated credible and high-quality ESG funds.”
For Childe achieving purity in a sustainable fund is down to the investor. “It is a personal decision as to what constitutes a pure approach for the individual investor and they need to understand the approach of the ESG manager in question and make sure that it aligns with their goals and values,” she adds. Isleib says that the definitions of ESG are broad, so investors have to know what the fund they are backing aims to achieve. “The manager needs to be explicit in terms of the portfolio’s strategy and the restrictions of the securities that they can invest in,” he adds. “These are important questions to ask and some of the bad press that comes is when investors did not fully understand what the intention of the portfolio was.”
Debates such as this might be rare in the future. Walsh foresees a time when investors will not be able to find a strategy labelled sustainable. “There is no doubt that one day there will be no such fund called sustainable, because all funds will have some element of sustainability in them.”
He adds that this is already happening. “If you look at investor behaviour it is quickly becoming minimum criteria for manager or fund selection.”