Quan Nguyen

Environmental and social issues have never been more important. The world’s eyes were firmly on Glasgow and the environmental issues discussed in the recently held 2021 United Nations Climate Change Conference (COP26).

As US President Joe Biden said during the conference: “There’s no more time to hang back or sit on the fence or argue amongst ourselves. This is a challenge of our collective lifetimes. [This is an] existential threat, [a] threat to human existence as we know it, and every day we delay, the cost of inaction increases.”

The investment world has long recognised these issues, with socially responsible investing (SRI) and environmental, social and governance (ESG) having been the hottest topics in the industry for a number of years.

How have investment managers responded to this interest?

To accommodate the increased interest, investment managers grew their offerings to include SRI variants and dedicated SRI managers have entered the market. The chart below highlights the increase in number of SRI-themed equity ETFs offered globally. ^[1]

The trend is rapid, with the number of offerings having increased almost nine-fold since 2014.

The number of funds managed with an SRI investment approach grew steadily until 2019, before accelerating over the most recent two-year period.

Whilst there’s been significant growth in this segment, the underlying strategies are diverse in their interpretation of SRI.

Different shades of green

If you ask 10 people what they expect in an ESG-focused fund, you’ll likely get 10 different answers. As such, we believe it’s important to understand the distinctions in approaches and history behind them.

The schematic below illustrates the evolution of ESG approaches over time.

Early examples of negative screens date back to the 1700s, when Methodist evangelicals avoided investment in a number of industries that they deemed harmful for themselves or their neighbours.

Unsatisfied with negative screens, investment strategies moved towards positive screens. The Domini 400 Social Index, which was launched in 1990, is an early example of an investment strategy that employs positive screens, only selecting companies with strong ESG principles.

Whilst elements of ESG integration are likely to have been considered since the dawn of investing, particularly regarding governance, ESG integration became increasingly common throughout the mid-2000s as the availability of ESG data increased. In 2010, the BP Deepwater Horizon Oil Spill highlighted the material impact that ESG risks can have on company valuations, with BP’s share price approximately halving in the three months after the disaster.

Following the establishment of the United Nations-supported Principles for Responsible Investment in 2005, managers have increasingly engaged with company management. Although this is typically performed to better understand company-specific ESG matters, if a manager believes a company’s approach to a certain ESG matter is inadequate, the manager may engage with the company and seek to positively influence its ESG approach.

Interest in thematic investing has accelerated in recent years, as investors seek exposure to trends and technologies that immediately address environmental or social issues, including health care, climate change and water solutions.

Whilst impact investing predominantly remains a strategy employed in private equity and debt markets, impact investing in public equities has seen strong growth in recent years. Managers offer portfolios comprising companies with technologies that address environmental and social issues, whilst providing additionality by providing primary market capital or targeted engagements.

Has money followed the hype?

Although there’s been growing interest in the SRI market segment for a number of years, investment flows were initially slow.

From a broader industry perspective, we’ve observed a steady increase in asset flows in SRI global equities strategies. The chart below shows the total funds invested globally into SRI-themed equity ETFs^[2].

As at October 2021, funds under management (FUM) attributable to SRI-themed equity ETFs was approximately $US 350 billion, representing a staggering increase of 2,200% from December 2014.

Can you have your cake and eat it too?

Its been a commonly held view that SRI strategies are ‘feel good’ investments that underperform traditional investments. Is this actually true? We analysed the average performance of five popular and longstanding SRI-themed global equities indices^[3] and compared them to the MSCI World Index over the past 10 years.

We found that the opposite is true, with the SRI-themed indices drastically outperforming the benchmark over the past 10 years, with outperformance attributable to the last two years.

It’s important to note that the indices performed broadly in line with the benchmark before the material performance divergence, which dispels the common notion that these strategies generally underperform.

So, it looks like SRI-focused investors might be able to have their cake and eat it too!

What’s your vice?

While it’s apparent that stocks which contribute positively to the environment and society are rewarded, how are traditional ‘sin’ stocks currently performing?

We identified the Advisor Shares VICE exchange traded fund, which predominantly invests in industries such as tobacco, gaming and alcohol. The chart below shows the performance of the VICE ETF against the MSCI World Index since its inception.

As the chart shows, investors are literally being punished for their sins in recent times. The stark performance differential between the SRI-themed indices and the VICE ETF highlights the shift in capital allocation towards ‘good’ companies by investment managers, on behalf of the underlying investors.

SRI and active management

With the outperformance of sustainable indices and the underperformance of the VICE Index, it’s apparent that active management can be a source of excess returns and risk reduction.

To assess this, we conducted analysis to determine whether an active manager’s approach to ESG opportunities and risks has had a material impact on fund performance. We grouped Zenith’s rated Global Long Only – Unhedged products by RI classification^[4] to determine a representative five-year performance for each cohort.

Given the relatively small number of thematic and impact funds on our APL, we’ve amalgamated funds from both cohorts for a more meaningful assessment. The chart below contrasts the performance of each cohort over the past five years.

Two key observations can be obtained from this analysis.

1. Strategies that have little or no consideration of ESG issues underperformed all other classifications.
2. Thematic and impact funds generated similar levels of performance as their aware and integrated counterparts.

While returns are an important consideration, we believe understanding the inherent risks involved with a particular investment is equally important. The table below captures the maximum drawdowns of each cohort over the past five years.

From this data set, it’s apparent that investment managers taking an active approach to the assessment of ESG matters have offered a greater level of capital preservation.

The future of SRI – a blurring of lines

While the diluted agreement that the world leaders reached at the COP26 may have disappointed many, the rapid rate at which the investment management industry has adapted provides some hope.

Looking into the crystal ball and judging from the current trend, we believe ESG integration will become mainstream and be the bare minimum expected for all investment strategies. Our view is shared by Larry Fink, the CEO of BlackRock, the largest fund manager in the world: “We are going to see evidence over the long term that sustainable investing is going to be at least equivalent to core investments. I believe personally it will be higher.”

By Quan Nguyen, Head of Equities Research

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[1] As recognised by Bloomberg Intelligence
[2] Ibid.
[3] FTSE Environmental Opportunities All-Share Index, S&P Global Clean Energy Index, MSCI Global Environment Index, FTSE4GOOD Developed Index and MSCI KLD 400 Social Index.
[4] For more information on the criteria of each RI classification, please see section 2.3.2.

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