In the past, it was often thought that investing sustainably comes at a cost – both in terms of lower overall returns and higher volatility. Today, however, the evidence is more nuanced. While short-term periods of higher volatility can still be expected, the longer-term relationship between sustainability and investment performance appears to be much more positive.
Past performance is not a guide to the future
When it comes to sustainable investing, testing the past impact on returns is difficult. After all, an appreciation of environmental, social and governance (ESG) factors has only developed as a separately identifiable approach over the last decade. There are also significant gaps in the data, as the availability and quality of ESG data has only recently begun to reach the point where investors can use it to make reliable assessments.
Nevertheless, while it may be difficult to find credible historical evidence of a link between ESG factors and returns, there are certain things we can say based on recent observations. The most obvious is that investing sustainably may result in short-term periods of volatility, depending on which sectors are doing well at a particular time. One reason why is that investing sustainably may involve excluding, or underweighting, companies in certain sectors, such as gambling, tobacco, nuclear power and arms manufacturing. When these sectors do well or badly, these sustainable strategies are likely to outperform or underperform significantly compared to market benchmarks.
Expect periods of short-term volatility
For investors with objectives beyond financial returns alone, short-term volatility or some sacrifice of return may be entirely acceptable. However, it is important to acknowledge that applying strategies such as sectoral exclusions in an attempt to invest more sustainably can have a significant impact on returns under certain macroeconomic circumstances. Most recently, the sharp rise in oil and gas prices that followed the Russian invasion of Ukraine has been deeply negative for sustainable strategies that have excluded traditional energy companies in favour of renewables.
The larger the weighting that the excluded sector has in a benchmark, the greater the outperformance or underperformance will be. The energy sector has a relatively large weighting in the UK stock market, for example, and also in high yield bond indices, so excluding traditional energy companies will have a larger impact on UK equity and high yield strategies when fossil fuel prices are high, than on markets where the influence of the energy sector is less pronounced.
The impact on long-term returns
While some sustainable strategies may be prone to short-term volatility, the impact of investing sustainably on long-term returns is less certain. What is clear, however, is that the amount of attention companies are expected to give to ESG issues has increased greatly in recent years, potentially putting those companies that fail to take sustainability considerations into account at a distinct disadvantage.
We would, for example, expect companies that incorporate sustainability considerations into their business models to be less impacted by tightening climate regulations, and to be better positioned to capitalise on new policy developments aimed at promoting sustainability, such as economic stimulus packages that reward emissions reductions or climate action.
Investors are also coming to recognise that companies can only deliver sustainable long-term growth if they manage the Earth’s resources prudently, treat their workers with respect and look after the natural environment in which they operate. At the same time, supportive government policy, new ESG regulations and rapid changes in consumer behaviour all have the potential to significantly impact the long-term profitability and potential performance of companies, with effects varying depending on those companies’ level of commitment to sustainability.
Those companies that fail to grasp the need to operate more sustainably risk suffering reputational damage and lower profits. Their shares risk becoming less attractive to investors as a result, and they could be deemed to be at higher risk of default on any bonds that they issue.
Do good and do well
The integration of financially material ESG factors means taking a wider range of financial and extra-financial risks, and opportunities, into consideration when making investment decisions. As a result, it should be clear that investing with sustainability considerations in mind can have an impact on financial returns.
While the exclusion of certain sectors deemed incompatible with a sustainable approach may lead to periods of short-term underperformance in some sustainable strategies, in the longer term we would expect an appreciation of ESG factors to be positive for returns as the world transitions towards a more sustainable economy.