Sustainable Performance – short term fluctuations, long term opportunities

As the world strives to achieve net zero carbon emissions and limit global warming to 1.5 degrees or less above the pre-industrial average, we are ever more mindful of the role that we can play in helping to achieve that goal alongside making good investment returns for our clients.

Our approach to sustainable investment is built upon 3 key pillars:

• Avoid – companies with socially damaging products or unsustainable business practices
• Invest – around themes and in companies which are either part of a sustainable future or will assist us on our pathway to it
• Improve - seek to improve the companies we do own by engaging with management.

Of course, with exclusions come questions around expected performance so we’ve spent some time analysing the impact of avoid criteria over the three years we’ve been running sustainable multi-asset products.

In context - the impact of Avoid

In 2020, many sustainable funds generated strong returns driven, in large part, by the companies not invested in – i.e. those in excluded sectors such as Weapons, Tobacco and Fossil Fuels. Comparing those excluded sectors, or the best proxies, against the broad equity market as represented by the MSCI World, we see underperformance across the board as Covid lockdowns curtailed global demand, particularly for energy. Value stocks generally underperformed too, hurting Tobacco.

Excluded sectors can differ markedly from the overall index

Then, in 2022, we saw a complete reversal. The war in Ukraine led to a spike in energy prices and demand for weapons, and a continuation of the Covid unlocking trend saw increased global demand for things such as travel, further boosting energy prices. The MSCI World underperformed these excluded sectors and, through not owning them, sustainable funds lagged. The conclusion we draw from this is that under and out performance will fluctuate over the shorter term for sustainable funds when driven by the ‘Avoid’ aspect.

When sustainable investing first began gathering momentum 40 years ago or so the exclusionary ‘avoid’ aspect was the primary focus of most funds. Sustainable investing evolved since then, and whilst exclusions have a role to play, there is growing emphasis on the ‘Invest’ element – the companies that can be either part of a sustainable future or will assist us on the transition to it.

We recently attempted to quantify the excess returns to stocks with strong sustainable characteristics^[1], after adjusting out all other factors such as sector or regional biases, market or factor (e.g. Growth, Value, Quality) beta. The results, shown in the graph, illustrate a generally positive trend from the data start point in 2014. There was a notable move higher during the period of Covid lockdowns as the technology stocks within the sustainable universe benefited disproportionately from optimistic expectations around a more permanent move to working from home, which then dissipated as society returned to working from offices to a reasonable degree. Health Care names also saw outperformance as successful Covid vaccines were developed and ultimately rolled out.

As with all trends in investment, the past is not necessarily a guide to the future. However, we believe the significant structural trends we see around us and the increased political willingness to use these issues to justify investment in green industries and reshoring will support sustainable investment over coming years.

As awareness of ESG issues, such as climate change, persists and gathers pace, we expect sustainable strategies to benefit from the increased desire of consumers, corporates, regulators, and governments to act on this. This, in turn, is likely and indeed already has led to significant allocation of capital towards solving some of the world’s sustainability challenges. Take the US Inflation Reduction Act (IRA) that was passed in summer 2022 for example. This is the most ambitious clean energy plan introduced in the US and provides fiscal support to the whole clean energy value chain to the tune of $360 billion or more. The EU has since announced its response, the Green Deal Industrial Plan. We expect these positive structural trends to continue, which could well benefit sustainability orientated strategies.

Conclusion

While we have seen that adopting a sustainable strategy can reduce the available opportunity set to some extent, there remains a large and growing number of companies that are suitable for inclusion in a sustainable fund. Investment biases can exist, but we see these as issues to mitigate through a thoughtful approach when constructing a sustainable strategy. Performance can certainly fluctuate vs traditional funds from year to year, but in the longer term we believe that much of the ‘noise’ will offset, and sustainable funds are well placed to benefit from the ongoing structural trends for years to come.

^[1] We classify stocks with at least 50% positive revenue alignment with the UN Sustainable Development Goals as sustainable. Stocks can be deemed sustainable with less than 50% positive alignment however require a mitigating factor such as good conduct. Further details on the UN SDGs can be found here: THE 17 GOALS | Sustainable Development (un.org) .