Whenever an investment theme becomes fashionable, a torrent of cash flows into the sector, with the result that valuations go higher and more cash goes in.
This can lead to investors being over exposed to certain sectors of the economy and the risk of bubbles emerging in those sectors.
Louis Florentin-Lee, sustainable equity fund manager at Lazard, says: “A top-down approach is likely to lead to a portfolio that is skewed to certain sectors, geographies or types of companies.
“The risk of a top-down approach is that these types of portfolios become too concentrated, offering clients a less attractive risk-reward balance.
“Furthermore, by focusing on a smaller number of sectors as part of a top-down approach, there is the added risk of overlooking some attractive investment opportunities in companies operating in sectors not obviously associated with sustainability.”
He says as sustainability is likely to have a wide-ranging impact, managers doing thorough research should be able to find great opportunities to invest across different sectors globally.
‘Hype cycles’
Craig Bonthron, global sustainable equity fund manager at Kames, says: “It is one of the challenges in terms of building a sustainable portfolio right now.
“Quite often a theme becomes very popular, and everyone piles into it. But, thinking in terms of themes is probably too simplistic.
“I think an example of that right now is probably robotics. There are some good robotics companies out there, but what is happening is funds are being launched to only invest in robotics, when in truth there are probably four good robotics companies, not 30, and it is 30 you would need to create a fund.”
Key points
- Thinking in terms of themes can be problematic
- When everyone falls out of love with a sector, that is the time to invest
- A sustainable portfolio will tilt towards quality stocks
He says that whenever an innovative investment theme comes to market there is a “hype cycle”, whereby everyone piles in and the price of the asset loses touch with the underlying fundamentals.
Mr Bonthron adds: “Then what happens is, the bubble bursts, and there is a slough of despond, where everyone thinks the innovation is useless. In truth, that is the time to invest.”
He says renewable energy is an area that “had its hype phase just before the global financial crisis, and then its slough of despond, so I don’t think it is in a bubble now.
“But the problem is that it is hard to know what to invest in – energy is a commodity, so ultimately, they are selling commoditised products and it is not easy to tell which of them is the best company.”
Renewables bubble
Katherine Davidson, sustainable equity fund manager at Schroders, says she thinks renewable energy may be in a bubble now.
For example, she thinks renewable energy supply chain stocks are in bubble territory.
Ms Davidson says the key to achieving diversification in a portfolio is geographical diversification.
She says the MSCI indices of sustainable equities tends to be very focused on companies in Europe, and reliant on a small number of sectors or themes.
Emerging markets
Ms Davidson prefers to look to emerging markets.
She says: “MSCI’s [environmental, social and governance] ratings favour European equities and large-caps primarily due to better disclosure, but this doesn’t necessarily reflect reality.
“For example, people perceive emerging markets to have lower standards when it comes to ESG, but what we have found is that disclosure is lower because there are fewer legal requirements, but many companies are just as well, or better, run.”
Mike Fox, global sustainable equity fund manager at Royal London, says: “Looking for sustainable investments in emerging markets means doing the opposite of what a global equity manager might do in developed markets.
“In emerging markets we find that governance has improved over the years, albeit from a very low base.
“We think the companies to focus on are those where the managers of the companies have large personal shareholdings, now outside of the emerging markets, that might be viewed as a negative, but in emerging markets it is positive, and central to how we get our exposure there.”
Diversifying your portfolio
David Winborne, equity fund manager at Impax, says the only way to achieve a truly diversified portfolio is to move away from a focus on benchmarks, such as the MSCI, and from any rigid focus on a particular style of investing.
In terms of investment style, Ms Davidson says: “While I think a sustainable portfolio can be well-diversified in most regards, it will tend to tilt towards quality stocks.
“Given the universe of truly sustainable companies is small, in my view, it is difficult to think of how one could make a portfolio of really sustainable value stocks.”
Mr Bonthron of Kames is another investor who sees opportunities in emerging markets.
He says at present it is difficult to see how the deep value style of investing could thrive in the present world of sustainable investing.
This is because some stocks are priced relatively highly, so are not cheap in a way that would appeal to value investors, while other companies, which he calls ‘emerging businesses’, are growing quickly and so do not really fit the criteria for a value investor either.
David Harrison, global sustainable equity fund manager at Rathbones, says there are about 3,000 stocks in the world he can look at, even after he has eliminated the companies that fail the initial screening for not meeting the criteria.
He says those 3,000 stocks comprise 80 per cent of the global equity market, and from those, about 30 are selected as meeting the criteria for investment, and placed into his fund, after a second screen is carried out to ensure it meets the sustainability goals of the fund.
Defining objectives
Ursula Marchioni, head of BlackRock portfolio analysis and solutions for EMEA, says: “Diversification when building a sustainable global equity portfolio can be achieved in different ways.
“The concentration risks could arise across sector, country and individual ‘E’, ‘S’, and ‘G’ criteria.
“Simply investing in companies with the highest ESG score could result in unintended biases towards specific regions, just as investing in companies with the highest measurable ‘impact’ could result in a bias towards the ‘environmental’ pillar.
“Therefore, it is important to first define the portfolio objective, and carefully monitor all characteristics to ensure that objective is fulfilled without introducing unintended tilts or concentration effects.”
Peter Michaelis, head of the sustainable equity team at Liontrust, says: “We invest across 20 sustainable themes and these give our portfolios diversified exposure to equities, with a few exceptions.
“Industries and sectors that damage society and the environment are susceptible to either enforced regulatory change and/or evolving consumer habits, both of which can be detrimental to long-term returns.”
Stephane Monier, chief investment officer at Lombard Odier, says he expects the Covid-19 pandemic to boost the investment case for many sustainable investment sectors.
He says: “Fiscal stimulus packages may provide a boost to green infrastructure.
“In the EU, at least, it appears likely that any long-term support programmes will be aligned to the EU’s green deal announced last year.
“Elsewhere, an increase in the availability of low-cost loans and capital will make investments in energy efficiency and renewable technologies more attractive, both of which require an upfront capital outlay but offer a positive economic return.”
David Thorpe is special projects editor at FTAdviser and Financial Adviser
