23rd Oct 2023 by MASECO Private Wealth

The Performance of Sustainable Investing


The Trillion Dollar Question

It may sound like hyperbole, but the question of how sustainable investments perform is actually more than a trillion-dollar question.  The Global Sustainable Investment Alliance estimates that over $35 trillion[1] of professionally managed assets incorporate sustainable investment criteria.  That fact alone almost answers the question.  We doubt that many investors would put that much money at risk of underperformance.  But there might be a whole host of investors in that group that expect to outperform.  So, will sustainable investments give higher returns, or perhaps provide lower risk?  We look at what the research shows, but first we examine the options available to the sustainable investor.

The Financial Returns of Sustainable Investing

Many investors remain confused about what to expect in terms of financial returns from sustainable investing. The money management industry does not shy away from claiming that sustainable investing offers higher returns and lower risk, while saving the planet. The marketing sounds great, but the reality is somewhat different.

The reality is that when investing you have a choice, because the type of sustainable investing you choose has a large impact on both your risk and your returns. In our earlier article we defined the three major forms of sustainable investing;

  • ESG or Environmental, Social, and Governance Investing
  • SRI or Socially Responsible Investing
  • Impact Investing

The Financial Returns of Impact Investing

Most impact investing requires putting your capital into private equity or private debt, or even individual projects. Financial returns in private markets can be extreme. Losing all of your capital, or making 10 times your investment, are both possible. Some impact funds that focus in areas like microfinance and affordable housing attempt to produce less volatile returns, but in private markets there are far more risks to consider. Private investments are illiquid, lack the investor protections of public offerings, and often go to newer, untested enterprises.  The impact investor is likely willing to accept these risks as they are seeking impact over financial returns in the first place.

The Financial Returns of Socially Responsible Investing

SRI investors seek to balance the pursuit of financial return with the incorporation of their values. For example, an SRI investor might exclude tobacco, gaming, alcohol, and gun company stocks regardless of their return potential. If the investor ends up excluding many stocks, or even whole industries, their portfolios are less diversified and can underperform. Historically, SRI funds have done just that. However, SRI investors might be willing to accept lower financial returns to match their values. If you have unfortunately had cancer in your family, the fact that tobacco stocks have had high returns may not be enough to convince you to hold them.

The Financial Returns of ESG Investing

ESG investing is different from the preceding categories. Most modern ESG strategies are not based on what is individually important to the investor. Instead, they are about what is important to the investments—companies are selected based on how they are dealing with the environmental, social, and governance issues most likely to affect them financially. 

There are ESG strategies built to deliver returns close to a market benchmark. Many ESG index funds and ETFs do just that. This makes ESG an option for far more investment applications. Investors, from large pension plans to individuals, that rely on their capital to meet future obligations often prefer ESG as it can be designed to deliver performance similar to conventional investments.

An ESG investor can also choose a strategy with more focus, perhaps investing in only sustainability leaders. Such funds tend to have more variable performance.  We are going to take a deeper look at what drives performance within the ESG investment universe next.

Examining the Research on the Performance of ESG Investing

Academics have responded to the demand for ESG by publishing countless studies on ESG performance.  But all these studies lack a critical ingredient that evidence-based investors crave – the statistical validity that comes with decades and decades of data. To make strong statistical inferences from stock market data, we prefer to have 60, 80, even 100 years of data to examine.  Those long run performance histories are what give us confidence that stocks have higher average returns than bonds.  And that bonds can, over the long run, beat inflation. Technically, ESG investing is less than twenty years old as the term was only coined in 2005. Unfortunately, we do not have those long historical returns for ESG.

We cannot say whether ESG portfolios will outperform or underperform conventional portfolios because we do not have the data to prove it. So, we turn to economic theory to understand what might happen. All those academic studies on ESG may not have been able to give us much data, but they have outlined the issues quite clearly.
Arguments for why ESG portfolios will outperform include:

Lower Risk – High ESG stocks produce less emissions and so might pay less in future carbon taxes.    They also face fewer product recalls, lawsuits, environmental fines, labor issues, etc.

Innovation Premium – Companies working on the cutting edge of sustainability will develop the new products and processes we will use in the future as we transition to a low carbon economy.

Momentum – High ESG stocks’ prices will rise because more and more investors are shifting capital to high ESG stocks and away from low ESG stocks.  
Arguments for why ESG portfolios will underperform include:

  • Diversification - ESG portfolios are less diversified than broad market portfolios.
  • Expenses – ESG funds and ETFs tend to charge higher fees.
  • Lower Cost of Capital – High ESG stocks are less risky and more attractive to investors, so they have higher stock prices.  These firms do not have to pay investors as high a return as other stocks.

Early sustainable funds were built mainly on an SRI approach, and many suffered from the drawbacks outlined directly above. Perhaps in an attempt to satisfy as many potential investors as possible, they excluded too many companies and even whole industries, and bought only well liked and high-priced stocks.  They were undiversified and charged high fees.  Underperformance was common.  Some commentators came to the conclusion that all sustainable investing underperforms.  But a closer reading of the research gives guidance on what methods contribute to performance and which detract.

MASECO’s Approach

We build portfolios that can take advantage of the positive potential of ESG while minimising the drawbacks. We focus on what we can control.  We make sure all our portfolios, both conventional and ESG, have broad diversification and competitive fees. And by tilting our portfolios to firms with high cost of capital, including small and value stocks, we make sure our portfolios are not just holding high priced stocks. 

The research shows that it is not necessary to underperform when investing for sustainability. Whether one is investing in individual stocks, indices, or funds, an investor can achieve market performance or better. Investors who want sustainable investing with good performance can do so provided they act with care. They need only to abide by the fundamentals of investing that the successful institutional investors subscribe to.

If you are interested in learning more about our sustainable investment solutions, we encourage you to speak to your financial advisor. We can build a portfolio that will help achieve your financial goals and reflect your values simultaneously.

[1] https://www.bloomberg.com/news/articles/2021-08-18/-35-trillion-in-sustainability-funds-does-it-do-any-good?leadSource=uverify%20wall

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Use of information

Nothing in this document constitutes investment, tax or any other type of advice and should not be construed as such.

  • The investments and strategies noted in this document may not be suitable for all investors and making available the information in this document is not a representation by MASECO that any investment strategy is suitable for any particular client.
  • This document is provided for information purposes only and is not intended to be relied upon as a forecast, research or investment advice.
  • This document does not constitute a recommendation, offer or solicitation to buy or sell any products or to adopt a particular investment strategy.

Risk Warnings

  • All investments involve risk and may lose value.  The value of your investment can go down depending upon market conditions and you may not get back the original amount invested.
  • Your capital is always at risk.
  • Although the information is based on data which MASECO considers reliable, MASECO gives no assurance or guarantee that the information is accurate, current or complete and it should not be relied upon as such.
  • The environmental, social governance (ESG) considerations in sustainable investing may affect the ability of product providers to invest in certain companies or industries from time to time.
  • Investment results of portfolios that do not apply similar ESG considerations to their investment process may differ.
  • To achieve sustainable investing, a product provider may need to: 
  1. limit the types and number of investment opportunities available to the product and, as a result, the product may underperform other products that do not have an ESG focus; and
  2. concentrate investment in specific sectors, countries, currencies or companies and exclude others resulting in a product that may be more sensitive to any localised economic, market, political, sustainability-related or regulatory events.

MASECO LLP (trading as MASECO Private Wealth and MASECO Institutional) is established as a limited liability partnership in England & Wales (Companies House No. OC337650) and has its registered office at Burleigh House, 357 Strand, London WC2R 0HS.  For your protection and for training and monitoring purposes, calls are usually recorded.

MASECO LLP is authorised and regulated by the Financial Conduct Authority for the conduct of investment business in the UK and is registered with the US Securities and Exchange Commission as a Registered Investment Advisor.

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