Friday Highlight  

Ethical investing: Kodak moment for the funds industry

Ethical investing: Kodak moment for the funds industry

The true market for ethical investing is hard to quantify given the nuances of definition and new products opening or repurposing regularly. 

It is dominated by institutional investors but the retail segment is growing rapidly.

A lot of historical criticism has been levied at ethical investing, stemming from the premise that restricting the investment universe of active managers of ethical mandates causes them to underperform their unconstrained counterparts. The evidence suggests this is not the case.

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1. Size matters

Data from the Global Sustainable Investment Association showed ethical assets grew 25 per cent over two years to reach US$23trn in 2016. Approximately $13trn came from Europe while around $7trn came from the US. Over the next 20 years inflows equivalent to the size of the S&P 500 are expected into ethical-related equity investments.

2. Shades of green

Ethical investing is not a standard one-size- fits-all proposition, and the approach has evolved over time as well as various nuances prevailing across different geographies.

The dominant ethical strategy in the UK is ‘engagement and voting’, in France it is ‘best-in class and sustainability’ themed, while in the Netherlands ‘negative and norms-based screening’ prevails. In the US, ESG integration is the most widely adopted methodology.

Ethical investing using environmental, social and governance (ESG) factors is fairly mainstream now for institutional investors, and is slowly being adopted by the retail market.

Newer concepts, such as impact investing, where investors can actively use their financial wealth to target specific issues where financial return isn’t the primary objective, are growing fast, in large part as a reaction to increased investor appetite.

3. Winds of change

In 2006 the UN-supported Principles for Responsible Investment was launched with 100 signatories, representing $6.5trn in AuM, committing to incorporate ESG factors into their investment analysis. Today there are over 1,400 signatories with AuM of $60trn. There are many drivers of change, but these three are considered to be the most prominent:

  • Regulation: Regulation and changes in accounting practices will drive sustainable investing from specialist to generalist and continue the mainstreaming of ethical investment styles. ESG regulation has doubled since 2015 and the number of laws relating specifically to climate change has doubled every five years since 1997. Few companies can sustain high levels of profitability and low levels of governance. Corporate and regulatory structures where companies support sustainable growth and foster innovation will be the leaders of tomorrow.
  • Demographics: You can’t fight demographics; 93 per cent of 18-29 year olds consider ethical considerations an important part of investing, with 85 per cent saying their investment decisions are a way to express their personal values (2016 US Trust Wealth and Worth Survey). Long established companies will increasingly have to change their products and services to adapt to a changing world. While this creates challenges, it also creates opportunity. As an example, the transition to electric-powered cars and autonomous driving has far reaching implications for many industries from car producers and oil firms to technology and insurance companies.
  • Climate change: US climate change focused funds have grown five-fold to reach approx. $1.5trn. As a result, climate change is the most significant environmental factor in the US when measured by AuM, rather than the views of President Trump. An estimated $90trn investment in cities, energy and land-use systems is projected to be made over the next 15 years, which should benefit ethical-aligned investment strategies. The University of Cambridge (CISL 2015) estimates the potential financial impacts of a shift in investor and consumer beliefs market sentiment about climate change impacts. Climate risks are not just long term - short term losses in portfolios could be 23-40 per cent in a world without strong climate policies and 10-11 per cent in a climate policy action scenario.

4. It’s good to be green

Ethical investments historically were seen more as a hobby than offering a competitive financial return. You invested because you wanted to do good, rather than achieve alpha. Today there is a growing argument that you can’t have sustainable outperformance without a sound appreciation of
ethical factors. 

According to a US SIF study (2016) of fund managers who incorporated ESG factors into their investment process, 80 per cent cited better returns as one of the top motives. 

A Morgan Stanley study found ethical investments usually met and often exceeded the performance of comparable standard investments and, further to this, a HSBC study noted improvements in ESG analysis drives share price performance, particularly in emerging markets.

5. Risky business?

Using US data, a Bank of America Merrill Lynch report found that an investor who only held stocks with above-average ESG scores would have avoided investing in 90 per cent of bankrupt companies seen since 2008.