Investing with purpose: what it means for returns
Sustainable investment strategies have performed well in recent years, often delivering higher returns than the broader market. But what can longer-term data, and financial theory, tell us about how they might perform in future?
We expect that over the longer term, returns from sustainable portfolios will be broadly similar to those of more traditional portfolios, despite often differing share price movements in the short term. A growing body of academic research now supports this view, as we explore in more detail below.
The last eighteen months have offered a clear illustration of how the “journey” of sustainable portfolios can be very different. Themes that commonly feature in sustainable portfolios – such as the transition to clean forms of energy – performed very strongly in 2020 as policymakers focused on “building back better” after the pandemic. The widespread exclusion of fossil-fuel stocks also helped. But it’s been a different story this year: so far in 2021, share prices of oil companies have rebounded, outperforming those of renewable energy producers.
This pattern of performance is not surprising. We do not expect the share prices of sustainable investments to outperform in all time periods.
For one thing, sustainable investments get caught up in other market dynamics. Precisely because of their impressive growth trajectory, energy transition stocks, such as renewable energy manufacturers, often fall into the category of “growth” investments. These have fallen out of favour this year as we have seen more cyclical, “value” stocks benefit from loosening Covid-19 restrictions and rising bond yields.
Valuation has an important bearing on performance too. Many of the sustainable industries we look at have attractive long-term growth prospects and strong momentum as more investors look to align their investments with their values. At times, this results in elevated valuations which can be a headwind for future returns. Conversely, industries with doubtful futures can still enjoy a "last hurrah," prompting dramatic share price rises if they are priced for imminent demise. This underlines the importance of integrating sustainable investment with risk and return analysis and adopting an active approach.
Companies can also change, as we explore in more detail below. We seek to use our influence to encourage the transition to a more sustainable approach.
Of course, profit is only half the story. In addition to strong risk-adjusted financial returns, our sustainable investment portfolios are designed to achieve positive real-world impact. By investing in companies that minimise carbon emissions, maximise social benefit and address some of the world’s most pressing social and environmental challenges, they are helping to drive better outcomes for people and the planet.
What do we mean by "sustainable" investment?
In 1982, the UN defined sustainability as "meeting the needs of the present without compromising the ability of future generations to meet their own needs". Or as Sir David Attenborough put it, "If you want to know if something is sustainable just ask yourself ‘can we do this over and over again forever’".
Sustainable investment means that we need to keep three things in mind at once social progress, the environment and economic development – or people, planet and profit. When looking at companies, this means we analyse both environmental, social and governance factors and their real-world impact.
Our sustainable investment portfolios are designed to create positive impact and attractive risk-adjusted returns.
What does the data say?
One inherent difficulty in assessing the performance of “sustainable investments” is that there is still so little agreement on the definition. Some providers give more focus to thematic investments, others to the exclusion of harmful areas. Financial data providers – such as MSCI and Bloomberg – even disagree on the fundamental sustainability characteristics of the same companies, often arrived at by examining so-called "ESG" factors: environmental, social and governance.
Depending on the weighting to each factor, the sustainability assessment can be materially different. For instance, one ESG rating agency considers Tesla a sustainability leader, given the importance of electric vehicles in the energy transition. But another provider feels the company's governance is poor, which brings their overall sustainability assessment down. We favour a rounded assessment of all aspects of a business. While a company's products and services may be addressing areas of need, if the business is acting poorly in respect to its other stakeholders, such as employees, then it is not truly a sustainable company.
This creates opportunities for active investors. Analysts equipped with the right tools and resources can gain information advantage – understanding the true sustainability characteristics of potential investments and identifying those which are best placed to succeed in a rapidly evolving regulatory, technological and social landscape.
Integrating sustainability factors improves risk-adjusted returns
Analysing the actual performance of such a sprawling, ill-defined universe is complex. However, recent research is finding ways to overcome these challenges. For example, a recent “meta-study” by the business school NYU Stern looked at 1,000 research papers produced between 2015 and 2020. By drawing on such a large body of research, it helps to identify the trends that are consistent across the different strategies and data sets that researchers might have focused on. The authors found that 59% of studies identified a positive or neutral relationship between the incorporation of sustainability factors into investment processes and financial performance. Only 14% identified a negative relationship. Significantly, studies with a long-term focus were 76% more likely to find a positive or neutral result. In other words, if you have a long-term time horizon, this data suggests that a sustainable portfolio is very likely to deliver a positive or neutral outcome compared to a conventional portfolio.
Results of the NYU Stern meta-study
The majority of investor studies found outcomes were either positive or neutral
Source: ESG and Financial Performance, NYU Stern, 2021
Another meta-study published in 2015 looked at over 2,000 empirical studies over the previous 40 years that examined the relationship between corporate financial performance and environmental, social and governance factors. This study also found a strong correlation, concluding that "the orientation toward long-term responsible investing should be important for all rational investors in order to fulfil their fiduciary duties and may better align investors' interests with the broader objectives of society."
Evidence also suggests that sustainable portfolios can be less risky than their conventional counterparts. This would mean that even if they ultimately deliver the same return, the risk-adjusted return of these portfolios is more attractive.
This was demonstrated last year, as investors digested the impact of the pandemic last year. Earnings estimates for more sustainable companies fell by a smaller amount than estimates for less sustainable companies.
Coronavirus crisis: Companies with higher ESG scores saw lower cuts to earnings forecasts...
Changes to EPS forecasts for 2020 made between 19 February 2020 and 20 March 2020
Past performance is not a guide to future returns. Source: Sustainalytics, IBES, BofA.
This translated into better market performance. Schroders’ European equity team found that companies which scored highly in CONTEXT, a proprietary tool that ranks companies based on their sustainability, fell by less than the benchmark. Companies that scored poorly fell by more than the benchmark.
|Performance 17 Feb-23 Mar 2020|
|Top quartile (most sustainable)||-29%|
|Bottom quartile (least sustainable)||-38%|
|MSCI Europe index||-35%|
Source: Schroders, FactSet, April 2020.
The greater resilience of sustainable investments in difficult markets is understandable. After all, a key part of managing a company for long-term, sustainable success means ensuring it is robust enough to navigate periods of volatility and change.
Other sources of data looking at previous sell-offs paint a similar picture. For instance, the MSCI ESG Universal Index, which includes companies with a strong ESG profile while minimising exclusions from the parent index, has clearly outperformed the MSCI All Countries World Index in past crises.
...and performed better in previous market crises
Historical performance of MSCI's ESG Universal Index vs MSCI All Countries World Index
Source: BlackRock, Aladdin
Using our influence: Sustainability improvers provide an opportunity to enhance financial returns
There is clear evidence showing that companies that improve their sustainability profile can deliver higher returns. This makes intuitive sense. Dealing with issues that can jeopardise a company’s prospects – whether it be a safety failing or disgruntled employees – should ultimately result in a lower cost of capital and a higher share price.
Often, when researchers discover a path to higher returns, the opportunity quickly disappears as investors rush to take advantage of it. That is unlikely to be the case here, as an influential 2016 study from Harvard Business School made clear. The study highlights the difficulties in identifying these opportunities as improvements in sustainability characteristics have to be material and are rarely clear in advance.
We believe the category of “sustainability improvers” represents a clear opportunity for our clients, both to enhance financial returns and achieve a positive impact. Our research process aims to identify those companies and managers that are best placed to take advantage of this opportunity. And we think we are in a unique position to use our scale to identify sustainability laggards and use our influence to help companies and managers transition to a more sustainable approach.
Academic research supports our emphasis on the importance of using our influence, also known as "active ownership." In one study, UK academics Dimson, Karakas and Li found that successful ESG engagements generate 7% excess return, with a 10% excess return for successful climate change engagements. This is a clear opportunity to create positive impact and positive returns.
Sustainability improvers feature heavily in our “core” portfolios. These portfolios reflect our longer-term views on the importance of sustainability but have more flexibility to own companies starting from a lower sustainability base. While our sustainability portfolios have some exposure to these companies, their focus is very much on sustainability “leaders”. A stronger sustainability starting point, and the pace and scale of change needed to address social and environmental issues, may help these companies to enhance their competitive positioning and technological leadership.
In both cases, our focus on engagement and using our influence allows us to drive the change that companies need to make, and once they have, ensure they remain best-in-class. It puts us in a good position to achieve both positive impact and better risk-adjusted returns.
Avoiding harm: screens have a minimal impact on long-term performance
Much of the debate around sustainable investment focuses on exclusions from portfolios - and the impact of these exclusions on returns. Schroders research shows that over the long term, the impact of exclusions on investment returns is minimal, though it can increase volatility in the short term. Applying exclusions such as tobacco or fossil fuels to a portfolio can cause returns to differ materially in any individual calendar year. However, returns remain similar on a longer-term, cumulative view.
The great convergence as we transition to a sustainable future
Evolving regulation, market pressure and consumer preferences will eventually lead most companies to realign their businesses to thrive in a fairer, greener world. Consequently, while sustainable portfolios may still be something of a specialism today, they will become the norm.
There are clear signs that this process is underway. For example, many of the largest oil companies have announced ambitious plans to source energy from renewables, while their peers, taking little action, look set to dwindle into financial irrelevance. In a decade or two, investors may well look at major equity indices and struggle to find companies that merit exclusion based on the sustainability screens of today. This trend towards convergence leads us to the view that periods of performance divergence between “sustainable” and “core” investment portfolios will be short term and temporary. The great prize in investing, as always, lies in “listening to the wind of change”.
This article is issued by Cazenove Capital which is part of the Schroders Group and a trading name of Schroder & Co. Limited, 1 London Wall Place, London EC2Y 5AU. Authorised by the Prudential Regulation Authority and regulated by the Financial Conduct Authority and the Prudential Regulation Authority.
Nothing in this document should be deemed to constitute the provision of financial, investment or other professional advice in any way. Past performance is not a guide to future performance. The value of an investment and the income from it may go down as well as up and investors may not get back the amount originally invested.
This document may include forward-looking statements that are based upon our current opinions, expectations and projections. We undertake no obligation to update or revise any forward-looking statements. Actual results could differ materially from those anticipated in the forward-looking statements.
All data contained within this document is sourced from Cazenove Capital unless otherwise stated.