Following a good run for many responsible investments, several trends have conspired against returns this year.
Responsible investing covers a variety of approaches that consider social and environmental good alongside financial return. Commonly, this is framed around a variety of environmental, social and governance (or ESG) factors, through which investors seek to make decisions about the risks and opportunities involved.
Many responsible investment funds have delivered strong returns in recent years, but 2022 has been more difficult for them for several reasons.
Commonly excluded sectors outperform
Most responsible investment funds exclude certain areas considered unsustainable or controversial either through a specific investment policy or by focusing attention on businesses bringing about overall societal or environmental good. Most avoid what are perceived to be harmful activities, such as tobacco, gambling or manufacturing weapons.
Instead they are often biased towards technology, healthcare and financials where there are more companies that fit a manager’s criteria. Some are focused on a narrower theme or group of themes such as clean energy. Performance is therefore expected to differ from broader funds and the wider stock market at times.
One particular area where responsible funds have little or no exposure is large oil and gas companies where the focus in terms of current production is on fossil fuels rather than renewables. Surging energy prices, exacerbated by Russia’s invasion of Ukraine, have been beneficial for their earnings and share prices. Defence companies have also performed relatively well as the global geopolitical picture has grown more fragile, and they are commonly a hard exclusion in such funds.
Inflation undermines growth
Many responsible funds have larger exposure to stocks and sectors that are higher priced but have faster growth potential. Areas such as technology and healthcare have suffered as expectations surrounding inflation and interest rates have changed. With these trending higher investors consider future profits to be worth less in today’s terms. Instead, some cheaper ‘value’ areas, especially those resilient to inflation including natural resources, have afforded investors a bit more protection in falling markets.
Some responsible funds are also more orientated towards smaller and medium-sized companies and away from larger businesses. That may be for thematic reasons – a smaller business tends to be more targeted in its activities – or because lots of larger businesses operate in sectors or are engaged in activities that are generally excluded. Smaller companies have been underperforming amidst recent falls and have a tendency to be more exposed to a slowing economy as inflation bites.
Responsible investing remains popular
The popularity of responsible investing has continued despite the recent headwinds, and we believe it has the potential to perform well over the long term. The need to create a more sustainable economy, as well as solve other pressing issues facing society, poses both opportunities and risks for investors.
A clear example is one of the defining investment trends we have identified in the past few years: the energy transition. This year has highlighted our continued reliance on fossil fuels for much of our energy needs, and with a large part of that supply compromised, significant reforms to the power price market both in the UK and across the continent are now likely. Part of the solution lies in renewables and although there are many hurdles to overcome renewable energy and efficiency initiatives are being geared up, a positive trend for lower bills and economic growth in the long run.