Investing sustainably does not have to mean sacrificing returns

Far from compromising investment performance, 'green' companies should outperform less sustainable peers.

Sustainable investing, by its very nature, means you have a smaller number of possible companies to invest in than an investor who does not invest sustainably.

How much of the market you rule out is dependent on how strong the sustainable principles are of the fund in which you are investing. For a sustainably minded fund manager who focuses on the UK, some funds have very strict sustainable criteria, which eliminate more than 60% of UK stocks from their available list, while others have less severe criteria, choosing to avoid only a couple of sectors – with some eliminating as little as 3% of available stocks. 

This reduction in available companies is one of the key reasons why many investors avoid sustainable funds and trusts: they assume that ruling out so many potentially profitable companies will hit their returns. However, recent evidence suggests that this is far from the truth.

Simon Holman, head of client investments at Castlefield Investments, which specialises in sustainable investment, believes that a smaller number of companies for sustainable funds to choose from could be one reason they are shown to perform better.

“By having funds that are adding in a wider range of factors to consider, you are getting a better analysis of a company and its financial risk,” he explains. 

He cites a 'study of studies' conducted by Deutsche Asset and Wealth Management in conjunction with the University of Hamburg in 2015, which looked at 2,000 studies since 1970 into the impact on returns of investing along ESG (environmental, social and governance) lines.

In 62.6% of studies, the use of ESG criteria had a positive impact on corporate financial performance, compared to just 10% that displayed a negative impact, it found. 

“It's an overwhelming bias for positive performance from [sustainable] investing,” says Holman, who also argues that changing attitudes towards ESG concerns mean it is those companies that tackle these challenges head on that are likely to prosper in the future.

“If you can find the companies that are implementing these factors, you are hopefully going to be getting companies that are the long-term winners.”

He continues: “A company will always have financial and non-financial risk factors. But if non-financial risk factors aren’t addressed then they can become material financial factors. Take BP’s safety fines, for example.”

The Deepwater Horizon explosion and spill in 2010 knocked more than 50% off the BP (LSE:BP.) share price, not surprising given that it resulted in eventual costs of around $65 billion (£53 billion).

A range of ESG indices created by Morningstar to analyse the performance of sustainable investment tell a similar story. The 56 indices cover a range of ESG themes, including sustainable leaders and sustainable environment, women's empowerment, minority empowerment and societal development. Of these, 41 have outperformed their non-ESG equivalents.

In 2015, Arabesque Asset Management analysed 200 academic studies to look at the correlation between sustainability and economic performance. It found 88% of studies showed that companies with solid ESG practices had a better operational performance, while 80% of studies showed that stock price performance is positively influenced by good sustainability practices.

Looking specifically at environmental sustainability, the Arabesque report found "a direct relationship between the environmental performance of firms and stock price performance".

It said positive environmental news triggers share price rises, while the opposite is true when firms behave environmentally irresponsibly and share price falls can be significant.

Arabesque's research also found that firms that are generally more polluting have lower stock market valuations. "Corporate eco-efficiency and environmentally responsible behaviour are viewed as the most important factors leading to superior stock market performance," the report stated.

Companies with more sustainable policies also benefited from a lower cost of capital – both debt and equity. Arabesque found 90% of studies showed a relationship between better sustainability practices and a lower cost of capital, which should support higher company valuations.

Meanwhile, a 2019 study from MSCI found data to support the idea that high ESG-rated companies "were more profitable and paid higher dividends".

Additional risk?

While there may not be any reason for sustainable funds to underperform over the long term, they may perform differently from other funds in their respective sectors over shorter timescales.

Holman explains: "If you don't own oil, gas and mining and they have a strong period, you're not going to be able to catch that, but equally when they aren't doing so well you won’t be affected in the same way."

In the case of tobacco companies, for example, avoiding this sector would indeed have compromised investment performance in the period up to 2017, but since those highs the sector has sold off significantly, benefiting those funds not exposed to tobacco.

"The shape of the performance profile will be different and will vary through the economic cycle," Holman adds. "You should still get a diversified portfolio – the risk will be different, not necessarily higher."

Others argue that you may have to take more risk with your portfolio.

Gareth Chalk, financial adviser at Blackstone Partners, notes volatility can be higher when certain sectors of the market are excluded. "As there is a more limited range of investment options, this can lead to a higher concentration of risk and resulting higher level of volatility. This means returns can be exaggerated compared to traditional investment portfolios – both going up and going down. People need to understand this - and be prepared to hold on through any bumpy rides."

Investor interest?

In 2019, the Schroders Global Investor Study found that 48% of UK investors either do invest sustainably or have a desire to do so, while figures from the Investment Association (IA) show that the amount of money invested sustainably has risen from £5.9 billion in 2009 to £20.9 billion by July 2019.

This may be the Al Gore effect, with the ex-vice-president of the US suggesting that sustainable investing "represents the biggest investor opportunity ever writ in history" and that the world is in the "early stages of a sustainability revolution" that had "the magnitude of the Industrial Revolution and the speed of the digital revolution".

The move towards greater sustainability and an avoidance of companies that are perceived to do harm could well be self-fulfilling for sustainable funds and trusts. Increased popularity of sustainable companies should increase their performance – and as more investors start to avoid certain sectors, such as tobacco, those investments are likely to disappoint. 

Conclusion

For many years, sustainable investing was deemed something of an oxymoron – how could you combine capitalism with sustainable responsibility? The idea that some fund managers could do better when they were forced to avoid sin stocks and sectors such as pollution, addiction or other questionable business practices did not seem to make sense if other fund managers had an unconstrained mandate and could invest where they liked. But the list of reasons to invest sustinably is growing, especially when you consider the possible reasons for better performance of sustainable investments - which include:

• Companies that take their responsibilities to society and the environment seriously having more sustainable business models than those who do not
• Governments regulating/punishing unsustainable business practices – for example, anti-bribery laws and investigations; markets for carbon emissions; requirements to recycle; restrictions on fixed-odds betting terminals
• Unsustainable businesses suffering as consumers shift away from their products – including big tobacco and diesel car manufacturers
• Sustainable products gaining from shifts in consumer sentiment – for example, rapidly growing demand for vegan products
• Activism, causing many investors to look at environmental and sustainable issues

Overall, the numerous studies that all point to an increased correlation between sustainability and performance and the increased interest in what we are doing to our planet means that sustainable investing is becoming far more mainstream and has moved away from its alternative reputation.

Rebecca O'Keeffe, a former head of investment at interactive investor, concludes: “Sustainable investing is hugely subjective. However, far from compromising investment performance, there is a growing body of evidence that suggests companies with good environmental, social and governance practices should be expected to outperform their less-sustainable counterparts, especially as interest in sustainability and the environment grows. Investors need to stop thinking that sustainable options limit their investment potential and think about ways in which they could help improve both the planet and their financial future.”