Even in 2019, Environmental, Social and Governance considerations (ESG) still bring with them a lingering, unspoken fourth word – ‘compromise’. Sustainable and ethical investment has long struggled with the idea that investing in line with your own moral standards must necessarily involve sacrifice – to be an ethical investor, you must give something up.
It’s an equation that we’ve historically seen in ethical decisions elsewhere – electric cars lack power and range, a vegan diet lacks protein – and taste – and sustainable travel sets you up for a miserable holiday. But it’s not true. Tesla has emphatically shown that electric cars have moved on from being boxy, range-limited slowcoaches, a vegan diet now offers amazing options, and try telling anyone cruising down the Douro valley that they’re not living their best life.
The Forum for Sustainable and Responsible Investment notes that $23 trillion in global professionally managed assets now factor in ESG and it’s set to grow, so it’s high time attitudes to ethical investing caught up. Recent research from Morningstar shows that sustainability and performance are far from being awkward bedfellows.
Where does the idea of compromise come from?
Back in 1971 the Pax World Fund was introduced. It was the world’s first ‘sustainable’ mutual fund and it focused on social responsibility. Since then many more funds have arrived with a whole host of other ESG leanings. The investor certainly now has much more choice than ever before, but the compromise equation comes from the idea that any ESG fund is by nature limited – it excludes things, therefore it’s incomplete. Investors worry about potential performance loss, that any limits imposed will lead to poorer returns simply because a fund isn’t free to play with a full deck. Modern portfolio theory itself suggests that by creating self-imposed limits, a fund sets itself up to be less efficient.
The thing is, now that we have several decades of performance to look back on, that isn’t what we’re seeing. In 2016, Morningstar’s Head of Sustainability Research, Jon Hale, dug into 25 academic studies of sustainable and socially responsible funds and portfolios, representing 12 years of research. He found that sustainable investing involves no clear performance penalty, so in 2017, he followed the returns for sustainable investments in the company’s own database and actually came out with a positive skew.
So what’s happening?
To go back to 1971, a purely ‘exclusionary’ screen, a mechanism by which a fund screens out the things it wont invest in – ‘sin stocks’ like tobacco, arms and pharmaceuticals – can impact a portfolio in a negative way. But like electric cars and veggie burgers, technology and expertise have moved on. Nowadays, very few sustainable and socially responsible funds use this blanket exclusion approach.
Modern tactics are more varied and more sophisticated – impact investing aims to generate social and environmental impact alongside a financial return, norms-based screening looks at investments according to their compliance with international standards and many thematic funds focus on specific or multiple issues related to ESG. The research examined by Morningstar suggests that modern ESG funds tend to outperform more often than they underperform, it even goes so far as to conclude ‘If anything, sustainable funds and portfolios perform slightly better than conventional ones.’
What about index performance?
The oldest index for sustainable and socially responsible funds was set up in 1990 – the (MSCI KLD 400). Since then, the performance of this and other socially responsible indexes has been generally in line with conventional ones. There are periods when they haven’t kept pace, like the dot.com bust years of 2000 to 2007, but then there are also times when the MSCI KLD 400 actually outperformed the S&P500 by a large margin, such as the late 1990s. That may be a while ago, but it shows that socially responsible investments are capable of keeping pace or doing even better than that. The studies that Morningstar reviewed also suggested positive relationships between companies that employ ESG best practices and their financial performance.
Stigma and statistics
The studies from recent decades show that there’s essentially no correlation between sacrifice and sustainability – you can have a diversified portfolio that performs well without having to lose sleep over the things that matter to you. Modern methods mean that focusing on best-in-class ESG practices rather than just exclusion, leads to much better results. It’s possible to achieve competitive performance and sustainability. The Morningstar research goes into detail on this subject, so we’ve included a link at the end of this blog.
What remains to be seen is how far the stats will have to go before the stigma of sustainability and compromise is lifted. It’s been a powerful and lingering association, but as The Forum for Sustainable and Responsible Investment points out, sustainability is very popular with millennials, a generation yet to hit its peak earning power. The number of sustainable and socially responsible funds still only makes up 1-2% of the global fund universe, but as we see a wealth transfer to that generation, we may also see ESG really hitting its stride.
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