Sustainable investing considers environmental, social and governance (ESG) factors in portfolio management. The Global Sustainable Investment Alliance (GSIA) carefully defined the various varieties of sustainable investing in 2012, from negative screening to corporate engagement and shareholder action. The popularity of these approaches as a whole has grown exponentially, with Google searches for the term ‘ESG investing’ alone ballooning in the last two years. As multi-asset investors, we believe it is essential to understand this surge in popularity and consider how it could best be articulated both as part of a standard diversified portfolio but also as a complete sustainable investment solution.
Legal & General’s April warning of impending climate disaster was only the latest in a series of similar communications by the major investment houses, demonstrating a new strand of advocacy which has traditionally been the preserve of environmental and other pressure groups. The rising societal prominence accorded to sustainability is being propelled by a combination of factors including millennial-led attitudes to equal rights and dignity, along with overwhelming evidence of environmental damage wrought by human activity. More broadly, we are living in a more humane and engaged world, with people’s philosopher Alain de Botton speaking of “The long march of kindness” in which humankind is generally becoming more aware of the suffering of others and – crucially – is more willing to do something about it. While responsible investing has existed for centuries and can trace its roots back to the Quakers, a slew of new indices and product launches are making specific forms of it more accessible than ever, without obviously compromising investment returns or adding significantly to costs.
Explosion in interest – Google search analysis gauges enthusiasm for sustainable investment:
Before exploring how these new trends could be incorporated in portfolios, it is important to highlight some of the main approaches to sustainable investing. One of the most accessible forms, especially in Europe, has been negative screening in which specific investments in companies involved in activities such as alcohol, adult entertainment, defence or fossil fuels are avoided. However, other methodologies are growing at a faster rate. Among these is positive or best-in-class screening, in which investment in sectors or securities are made on the basis of positive ESG scoring relative to peers or indices. There is also corporate engagement or shareholder action, in which shareholder influence is used to influence management behaviour for the better. For the purposes of this article, we will focus on positive or best-in-class screening since it is efficient to implement within a diversified portfolio and easily articulates the broad-brushed investment preferences (asset class, region, style) that characterise multi-asset investing.
With this in mind, we consider how and why a ‘standard’ diversified portfolio would take on elements of positive screening to articulate a given investment view. As mentioned, the ‘how’ is becoming simpler, with an increasing range of passive and active funds in equities and fixed income(including credit), all emphasising positive ESG progress relative to their respective indices. A given market allocation within a multi-asset portfolio, say in European equities, can now be easily replaced with an equivalent fund demonstrating a higher ESG score. But why do this at all? The answer is because sustainable investing carries its own, compelling investment case. According to a 2016 Bank of America study1, over the next two to three decades the millennial generation could put between USD 15 - 20 trillion into US-domiciled ESG investments, which could double the US equity market. In our view, this approaching wall of money makes holding an ESG-screened index in one of the major markets a valid theme in its own right and one which could complement existing equity themes such as technology or the rise of emerging markets (EM). While one ESG-positive holding does not make for a sustainable portfolio, as a standalone investment play it is compelling in our view.
From here, it is not a huge leap to the creation of a complete sustainable multi-asset investment strategy via positive ESG screening. The first point of principle is that asset allocation, and in particular the right asset allocation at the outset followed by regular rebalancing, is the main determinant of long term investment success. As Andrew Ang wrote in 20122, “The foundation for a long-term investment strategy is rebalancing to fixed asset class positions, which are determined in a one-period portfolio choice problem where the asset weights reflect the investor’s attitude toward risk”. This main driver of investment performance would not need to change, instead portfolio construction could now utilise sustainable investments, in particular positively screened funds and securities whose ESG scores are significantly higher than equivalents. Up until recently, articulating a complete multi-asset portfolio through funds in this way would have been daunting but today major regional equity indices such as the US, UK, Europe, Japan and emerging markets (EM) are all available in high ESG-scoring forms, although it should be noted that actively managed vehicles promoting sustainable investing have existed for some time. In addition, specialist data providers can provide ESG scores of most listed securities and bonds, allowing further insight into underlying holdings of available funds and therefore enabling a diversified portfolio to be constructed with a target ESG score in mind.
If using indices, our assessment is that fees in most cases appear to be only slightly higher than non-ESG equivalents, with one major provider’s positively-screened S&P 500 ESG fund charging little over 10bps a year. And while it is true that factor-based index funds giving exposure to the Value, Momentum and Quality styles in an overtly sustainable package are not yet available, it is highly likely that they will be so in the next few years. And looking at select examples of ESG-screened indices, there appear to be no adverse performance consequences versus standard equivalent indices. The MSCI Europe ‘ESG Screened’ index has performed in line with its non-screened equivalent while the MSCI EM ‘ESG Leaders’ index has outperformed. This may partly be because in EMs governance can be a significant determinant of corporate profitability. But overall it is reassuring to know that sustainable investing does not appear to involve a significant performance sacrifice. If anything, the current trajectory of investor interest suggests that articulating portfolios with positive ESG-promoting funds and securities should provide a source of active value-added to portfolios in addition to the all-important asset allocation.
From minimal sacrifice to outright outperformance – ESG index comparisons:
Past performance is not an indicator of future performance and current or future trends.
Past performance is not an indicator of future performance and current or future trends.
Regarding fixed income and alternatives, the sustainable universe is less plentiful but is starting to develop. Within the former, investment grade, high yield and EM bond index funds are available but alternative bond approaches such as insurance-linked and MBS (mortgage backed securities) have not had the ESG treatment at the time of writing. It should also be noted that research has shown that while a modest yield sacrifice is generally made for holding ESG-positive corporate bonds, funds, tend to outperform their non-ESG equivalents during market sell-offs, such that over a full business cycle the differences are minimal. An ESG-promoting fixed income allocation is therefore perfectly feasible in a diversified portfolio. But in alternative investments, the universe – particularly in UCITS vehicles – is already limited even before adding the sustainability requirement. Nevertheless, acceptable diversification from equities could still be achieved via higher allocations to investment grade and government bonds, as well as cash.
In conclusion, we believe the time is right for selected ESG-promoting investments to be considered both from a standard portfolio perspective and with a view to building complete multi-asset strategy solutions. In terms of the former, deploying an ESG-promoting element within a standard portfolio is perfectly acceptable since such investments are likely to benefit from the investment ethos becoming standard practice over the next few years. For a portfolio where a high ESG score is part of the stated objective, then the portfolio construction following the initial asset allocation will demand an all-in approach which promotes and monitors ESG-positive articulation via specialist funds or carefully constructed baskets of securities. While the sustainable investing universe still has some way to go, with regards to funds, it has now reached a stage where it is possible for multi-asset portfolios to help make the world a better place at little cost to the investor. This is a theme we will be exploring carefully as investors seek to transition their otherwise standard portfolios into ESG-positive equivalents.