Over the last few years, we have started to see growing signs that climate change is a material risk issue. Is capitalism the cause or a potential solution to this emergency? If it is the latter, then capitalism needs to transition to sustainable capitalism that recognises a wider range of essential issues affecting people and the planet. Whilst the investment sector is beginning to get its head around the need for this transition and the power of its capital in making that transition, I believe many aspects of sustainable investment are still misunderstood.
One of the most frequent arguments against sustainable investing is that there is a trade-off between sustainability and financial performance. Many critics argue that it limits the investment universe, curbing potential returns from the highest-performing assets, but the data tells a different story.
A recent Morgan Stanley study of more than 10,000 mutual funds found that sustainable equity funds usually had equal or higher median returns and equal or lower volatility than traditional funds. Oxford University and Arabesque Partners Meta Study analysis found a positive relationship between sustainability and financial performance of stock prices for 80 per cent of the 200 sources reviewed. Analysis tends to suggest that firms considering ESG issues can increase returns and/or reduce risks compared to those that don’t. They also have a lower WACC (weighted average cost of capital). Research from the Journal of Sustainable Finance & Investment on behalf of Deutsche Wealth Management and more recently Morningstar Financial Research reached similar conclusions. Morningstar Financial Research compared the performance of their ESG-screened indices to their non-ESG equivalents and found that 73 per cent of the ESG-screened indices outperformed their non-ESG equivalents. So, the evidence that there is no need for any trade-off between sustainable/responsible investing and alpha has reached the point where it can no longer be ignored.
Sceptics of sustainable investing also commonly claim that it violates “fiduciary duty,” or the investor’s legal responsibility to make investment decisions in the best interest of the beneficiary. This duty is often articulated as a requirement to maximize investment returns to the exclusion of all else.
The opposite is in fact true. Based on the research above it is clear that identifying material ESG factors is important to fulfilling “fiduciary duty.” Robust corporate sustainability practices—including those that improve energy use or reduce waste—can be material factors because they can lower the cost of capital for companies and improve operational performance. Considering the sustainability performance of investment opportunities is often explicitly in the best interest of investors, and therefore fully in line with fiduciary duty. Understanding how investments integrate sustainability and deliver a net positive impact on both the environmental and social frameworks, whilst also generating economic returns, should now be a critical part of the investment process. Further, ignoring ESG factors may soon be recognised as a failure to fulfil fiduciary duty.
We tend to think mostly about equities in the context of sustainable investing, but other asset classes are increasingly engaged in this approach. With fixed income instruments, ESG analysis helps identify a wider range of risks to a borrower’s ability to service debt. Well-managed companies should be less likely to incur value-destroying activities or controversies, making their cashflows more stable, less volatile and consequently better positioned to service debt. So much so that mainstream credit rating agencies, who were initially sceptical of the value of sustainability analysis, have acquired or developed ESG analytics capability in response to these developments.
In illiquid asset classes investors must have a longer investment horizon as capital is potentially locked up for years. This is very true of private equity. Considering ESG factors here is crucial as investors want to be confident that companies are managing future or long-term risks that may not have materialised yet rather than focusing on quarterly earnings figures.
When integrated with more traditional methods of measuring a company’s prospects, sustainable investing has the potential to improve assessment and enhance performance. This makes sense because ensuring companies, industries or markets are operating leanly and maintaining resilience over the long term positively affects their long-term performance. It might mean excluding certain companies or industries on the basis that they face deep-seated problems that make them poor long-term investments. In this respect, a sustainable investment strategy, particularly a private equity one, is aligned with many of the principals of Sharia Law, in particular those of applying ethical standards, risk sharing and developing long term relationships
Delivering a sustainable form of capitalism is the challenge, but it is something that those in the investment management industry must work towards for a sustainable future for all.
Saada Saab Antypas