Myth: ESG portfolios underperform
Gone are the days when ESG (environmental, social and governance) was considered a niche approach to portfolio management, restricted to ‘tree-hugging’ ethical investors passionate enough about the impact of their investments that they would be willing to sacrifice strong returns.
ESG investment strategies have opened up to the masses, and as heart-warming as it would be to solely put this down to a moral and ethical shift in society, if the returns were not hitting the mark, we would not have seen the steady increase in demand for ESG investment options that has occurred in the last 15 years (see below graph).
It is a common misconception that ESG portfolios underperform. In 2019, investment research firm Morning Star surveyed the performance of 745 Europe-based sustainable funds and concluded that the majority of ESG strategies performed better than traditional funds over one, three, five and ten years.
Looking at seven categories of ESG funds, in the ten years leading up to 2019, the Morning Star study revealed that not only did a greater number of sustainable funds survive than their traditional counterparts (72% vs. 45.9%), but over the decade, nearly 59% of the surviving sustainable funds outperformed their non-ESG counterpart.
Capital’s ethical portfolio, Fusion ESG, is an actively managed portfolio consisting entirely of ESG funds with a focus of positive impact strategies and resource sustainability. As illustrated below, Fusion ESG has a near 10-year track record of performance that compares well with the ARC Balanced PCI benchmark.
Myth: Sustainable investing is based on exclusion strategies
Exclusion strategies use predetermined criteria to decide which stocks should be excluded from an ESG portfolio. Within these strategies, stocks are screened out because of the negative impact of their business activities on the planet and society. This is a method that has been used for decades but remains largely subjective; there is no algorithm for determining whether a stock is inherently ethical.
For a more objective approach, as part of their equity research, some investment managers (Capital International included) give a numerical ESG rating based on analysis of corporate activities from an ESG perspective.
This approach helps to put a quantitative process in place to establish a view on whether an asset meets the manager’s criteria or whether the asset should be excluded from a portfolio with an ESG mandate. The method however is still prone to qualitative judgement calls.
Inclusion strategies on the other hand select stocks based on their positive impact. As we can see from the below diagram, this approach is much rarer than negative screening; it has however become more common in recent years.
We have also seen an emergence of ‘best in class’ selection which, while often grouped with positive screening, is in fact quite different. A best-in-class asset describes the top ESG performer within a given sector. This however does not necessarily mean that the stock is a positive impact stock; it could simply be the best of a bad bunch.
With investment managers employing such a range of stock selection strategies, investors can easily be misled when looking into ESG options. Asking the right questions and gaining a good understanding of your chosen provider’s strategy is therefore key in ensuring the impact of the portfolio meets your expectations.
Myth: ESG can only be applied to equities
Whilst the majority of ESG strategies consist of equities, as illustrated above, ESG bonds have existed for a long time and the market is growing.
In 2019, 479 green bonds were issued globally, representing a 25% year-on-year increase. This momentum did not slow in 2020 with a record of $50 billion in green bonds issued in September alone.
Green bonds have existed from as early as 2007, with one of the earliest examples established by the World Bank the following year. This particular fund supports projects that mitigate climate change or help people affected by its consequences. Since its inception, the World Bank has issued more than 13 billion USD in green bonds through more than 150 transactions in 20 currencies.
In more recent times, Agence France Trésor (the body which manages government treasury in France) launched its first green sovereign bond. Created in 2017, its initial issuance volume totalled seven billion euros. Following suit, UK Chancellor, Rishi Sunak, announced earlier this month that Britain will issue its first ever green government bond in 2021, after seeing an increased demand for fixed income investment opportunities that support environmentally friendly initiatives.
Myth: Sustainable investing is just a trend
There has been a steady growth in ESG demand over the last 10 years which can largely be attributed to an increased awareness of ethical issues. Both individuals and governments have woken up to the state of the planet and are finally taking action to minimise their impact.
This shift in attitude in society and government is mirrored in investor behaviour. A survey conducted by private bank Brown Brothers Harriman (BBH) found that in the next five years, almost a fifth of ETF investors intend to have between 21% and 50% of their portfolio invested in ESG funds.
It is not just an attitude change that is seeing ESG interest soar. The frameworks around investing ethically are developing quickly and companies currently managing to conceal a few nasty, non-ESG truths will soon be left with nowhere to hide.
Earlier this year, the WEF published a white paper on ESG which highlighted 21 core metrics and 34 expanded metrics for measuring ESG impact. The paper was compiled with input from the big four accountancy firms as well as more than 140 global business leaders. This development is potentially transformative for investors. As investment managers begin to adopt the metrics as part of their ESG screening processes, companies seeking investment will be compelled to disclose the true impact of their business activities or face being starved of capital. This shift could see even the old industrial giants change their ways in a bid to avoid being forced out of the market.
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