Sustainable investing today is more complex than ever before. Building a diversified sustainable investment portfolio may involve many considerations but it makes sound financial sense.
The sustainable investor of today is a far cry from the passive activist of the early 2000s. The principles of Environmental, Social and Governance (ESG) came into use well over a decade ago. However, they predominately described a process of negative screening, whereby only stocks considered harmful were excluded. These were typically limited to tobacco and armament companies.
The changing focus of sustainable investment managers
Sustainable investment management has gradually evolved to a point where managers positively screen equities and bonds to choose companies with a progressive approach. A new breed of active investors believe they have more influence on sustainable outcomes by investing with fund managers that encourage corporations to improve environmental and human wellbeing over the long term.
The fund manager may choose to focus on a number of things, including:
Why advising on sustainable investing is becoming more complex
As investment advisers, helping clients achieve their sustainable objectives is complex, particularly as one person’s sin might be another’s virtue.
Sustainable investors themselves often hold differing views. While few would question the exclusion of tobacco or armaments companies from a sustainable portfolio, issues such as alcohol, animal testing and genetically modified crops often divide opinion. Given the huge expansion in sustainable investment products we also need to remain alert to potential greenwashing as new entrants quickly launch new funds to compete in the ESG space.
Investing in energy companies
The Government recently launched Greening Finance: a roadmap to sustainable investing. The document sets out an ambition to position the UK as the “best place in the world for green sustainable investment’. Crucially, it focuses on investment decisions to factor in climate change and the environment.
One question which comes up repeatedly is whether energy and resources companies should be included in sustainable portfolios. An obvious choice might be to avoid all companies involved in the extraction of fossil fuels, but this is a risky strategy. It could be argued that if all responsible investors were to divest from energy stocks, energy companies would be left solely in the hands of investors only concerned with the maximization of profits, at the expense of creating a greener future. As it happens, many energy companies benefit from powerful, active shareholders who actively engage to help bring forward the world’s carbon reduction objectives.
As it stands, most UK-based sustainable investment managers will exclude any company involved in the production of nuclear energy. To date, the anti-nuclear campaign has been strong, driven by the memories of horrendous historical accidents and concerns over pollutants from spent nuclear fuel.
But the recent critical surge in natural gas and oil prices, which threatens to devastate low-income households this winter, could prove a catalyst for sustainable investors to change their position. Nuclear provides a carbon-neutral energy source that could fill the gap between other, intermittent renewables and fossil fuels. With the world struggling to meet its goal of limiting global warming to less than two degrees, it could provide the medium-term solution.
Sustainable investing is smart investing
The debate over what constitutes a sustainable portfolio rages on. Meanwhile, returns from almost any sustainably-labelled fund have soared over the past decade, laying waste to the idea that the sustainable investor must sacrifice returns for principles. This halcyon experience has been driven by three factors.
1. Sustainable companies represent value
First, and most importantly, truly sustainable companies represent value. Well-run companies which sell products and services that benefit humanity, society and the environment should always trade at a premium.
2. The growth of sustainable mandates
Second, a tremendous amount of money has been allocated to sustainable mandates in recent years as more people want to invest in sustainable companies. The funds that service these have a limited universe of investments, and with significant sums of money chasing the very same of assets, prices have increased.
These two factors are completely rational, and will likely continue to dominate until more suitable investable assets reach the market.
3. Sustainable ventures are often high growth
There is another reason why sustainable assets have performed so well over the past decade. The companies most likely to find their way into sustainability portfolios are often in high-growth areas such as technology.
These companies often trade at high multiples to their current earnings as investors price in future earnings growth. To understand why high-growth companies have performed so well over the past decade, we need to look at what has been happening to the across the equity’s spectrum as well as in the debt markets.
On the debt side, over the last ten years, we have seen a collapse in government bond yields. From July 2009 to July 2021, the twenty-year UK government bond yield fell from 4.74% to 1.02% per year. The inflation adjusted annual return of a thirty-year UK government bond fell even lower, to about minus two percent. The fall in these longer-dated interest rates has made them quite unappealing compared with equity markets.
Falling yields have been a major contributor to rising equity markets. The value of a company is the present value of its future cashflows. Therefore, as the discount rate used to calculate the present value falls, the theoretical value of the company rises. This is more pronounced in growth companies where cashflows are further out in the future and therefore are more sensitive to a change in the discount rate. Put simply, the opportunity loss of buying a company now for cashflows in the future is lower as interest rates fall.
It is not for me to call the bottom of the interest cycle, but in late September we saw markets start to recognise the rising risks of inflation, notably in the energy markets. This led to a rise in longer-term interest rates and relative underperformance of growth equities. This led sustainable portfolios to underperform. It is yet to be seen if this trend will continue.
Building diversified portfolios
If interest rates rise, sustainable assets are likely to exhibit much higher levels of volatility and potential drawdowns. With this in mind, at Thomas Westcott, we believe it is wise to build diversified portfolios of self-styled multi-asset sustainable funds. This means investing in managers with strong track records and a history of sustainable fund management.
Gone are the days of the armchair activist, at least as far as sustainable investment is concerned.