The Shift to Sustainable Investing
By Michael Lane
My first experience with sustainable investing was in 1995 developing a solution for advisors that incorporated a separate account for a socially responsible investment. After a significant amount of work, the account never received assets and that experience influenced my thoughts about environmental, social, and governance related investments for decades. I was like many that would suggest it is one of the most important areas of investment development -- but also the most underutilized.
Among the financial advisors that I speak with, many of them have viewed sustainable investing as a niche investing strategy at best. More than a few believe the approach means sacrificing performance in exchange for personal values. For a long time, to be honest, I have had some sympathy with those points of view. But, times have changed.
Sustainable investing combines traditional investment approaches with environmental, social and governance (ESG) insights and have offered competitive risk-adjusted returns over the long term. I’ve changed my mind about the approach, and I now believe sustainable can potentially deliver performance and value for investors. It’s not just me: I’ve seen a similar shift in the industry as more and more advisors are embracing sustainable solutions, and not just because of a social or environmental preference, but for pure investment purpose.
In my conversations with advisors, I see four main reasons driving this shift.
One of the main critiques of sustainable investing that I’ve heard is that you sacrifice performance. You limit investing, the argument goes, in companies that may not be doing things you personally like but can offer good returns to help meet your investing goals. It turns out, however, sustainable investing may not come at the expense of investment performance. In fact, ESG strategies have offered performance in line, sometimes actually better, with the broad market with high correlation. For example, the MSCI USA Extended ESG Focus Gross Total Return Index had two year annualized returns of 1.79% from April 2018 through the end of March of this year. In other words, this is a period that included both the bull market of 2018-19, and the market turmoil of Q1 of this year. During the same period, the MSCI USA Gross Total Return Index returned .82% with a correlation of one between the two indexes. To be sure, this is no guarantee of future performance, but at least it demonstrates that in recent history, with a range of market environments, sustainable kept pace with the traditional approach.
Companies that exhibit positive ESG characteristics also tend to be high quality firms, with strong balance sheets, relatively less debt, more stability, and strong corporate governance. Such companies may help position portfolios for the future, something that is particularly important as investors adjust to new and ever-evolving realities of the Coronavirus world, with uncertainty and potentially more volatility ahead.
ESG data is improving.
Rating a company on ESG metrics seems like it should be straightforward, but it is surprisingly complex. Is a company truly sustainably focused if their suppliers are not? Questions like that create complexity when accurately scoring one’s true ESG footprint. But that’s changing as the information that feeds into sustainable indexes has improved significantly in recent years. Companies have been better about divulging more information about their sustainability practices, and there are better frameworks to help companies decide what ESG information to disclose and how to do it. That’s important because more and standardized ESG data drives better ESG indexes and improves measurability for how companies are changing their sustainability practices such as governance or health and safety behaviors.
Clients are asking for it.
Savvy advisors respond to client demand just like any smart businessperson and more investors are asking for sustainable choices for their investment portfolio. According to Morningstar, 72% of the U.S. population has expressed interest in sustainable investing3. This seems to be true across all demographics, but particularly so among younger investors like Millennials, who are becoming increasingly important to wealth managers now and in the future for wealth management, not just in this country, but around the world. Advisors who ignore this demand do so at their own peril. In other words, it’s not about your own personal beliefs, but about meeting client needs, be it for purity of investment strategy, or just opportunities for improved outperformance relative to a benchmark, or alpha.
It’s easy to do.
With the improvement in ESG data quality and availability, sustainable indexes and products that seek to track them are now available for almost any use case. Indeed, creating an entire portfolio out of sustainable funds was all but impossible until recent advances in indexing. Since indexes can now give investors convenient and efficient access to numerous sustainable equity and bond approaches, these building-block exposures can also pave the way for advances in portfolio construction. Perhaps most important for advisors is that many sustainable strategies are built from the industry’s most popular broad benchmarks. That means advisors can build a sustainable approach for their clients without fundamentally changing the clients’ asset allocation exposures.
I understand why many advisors are skeptical of the sustainable approach. It may defy their personal beliefs, as well as their past experience with sustainable investing. But the world is changing -- as is sustainable investing -- and advisors will need to adapt to it. Their clients are increasingly demanding it, and we expect the growth of interest in sustainable to continue in the years ahead. The good news is that sustainable can help drive business for advisors as they continue their commitment to meeting their clients’ needs. I will admit, I was a skeptic, but now I’m an investor myself.
The views and opinions expressed herein are the views and opinions of the author and do not necessarily reflect those of Nasdaq, Inc.