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ESG investing: governance and performance go hand in hand

27 February 2020

“Sustainability should not drag down returns but investors tapping into the zeitgeist must look carefully for the best opportunities”, says Lorna Robertson, Head of Funds at Connection Capital


With the climate emergency lighting a fire under public consciousness, sustainability and ESG (environmental, social and governance) investing are entering the mainstream. A target date of 2050 for net zero carbon emissions has been set in the UK. The Bank of England is leading the debate around how climate change could impact financial stability and asset values . Blackrock, the world’s largest fund house, has pledged to re-focus its business on sustainability . And European investors have doubled their allocations to sustainable funds in the space of just one year to a record €120bn according to Morningstar, the data provider .

The dial is moving partly due to a heightened sense of social responsibility, as pension funds, for example, are increasingly mindful of how the pensioners of tomorrow want their money to be invested today. Plus, there are reputations to consider. And partly, it is borne out of a growing realisation that there is massive growth potential here. Regulation is re-shaping markets, and there are some excellent opportunities out there. The renewable energy infrastructure space is a good example. It has been rapidly professionalising, while market dynamics have simultaneously improved, with rising demand, enhanced capacity and falling prices .

Though the benefits are becoming clearer, there are two key questions many in the investor community still need answering. One is, by tapping into this zeitgeist, will performance be sacrificed? And the other: how to invest in sustainable funds in a way that really delivers ethical and financial value?

Portfolio versus planet?


The first thing to say is that an ESG-compliant strategy need not create a drag on returns. Proof points are already emerging: according to the IMF , the performance of sustainable funds is comparable to that of conventional equity funds, though it notes that there are still comparatively very few of them. In fact, such a strategy can help make portfolios more resilient by offsetting the risk of green policy changes and regulation (which is tightening all the time) on other assets.

What’s more, good governance should underpin performance. If ESG principles are embedded in the structure of the investment, rather than simply layered on top, and fund managers are truly committed to these principles rather than just paying lip-service to them, then those managers are far more likely to have what it takes to drive good returns. Just as with other types of investment, having the specialist expertise to source quality opportunities, carry out due diligence in this complex area, and ensure that the right framework is in place to deliver on promises is essential.

With ESG gaining momentum, more and more fund managers are going to have to integrate it into their investment strategies. However, there is often a tendency to focus on excluding sectors (e.g. fossil fuels, tobacco, weapons or gambling companies etc), rather than thinking proactively about what should be included. Now that everyone seems compelled to make sustainability statements, questions will be asked about how compelling they really are. Investors must look closely at the detail to differentiate between them.

That means understanding not just what a fund’s ethos is but how deeply it is ingrained and what its credentials are. What is its track record in this area? How does it assess opportunities? How does it demonstrate accountability to stakeholders? In what other ways does it contribute to a better, fairer, more sustainable world, for instance through community engagement and outreach? The latter may seem relatively insignificant but can be very telling. Sincerity matters.

Differentiating factors

As competition for sustainable investments inevitably heats up, it follows that finding high quality opportunities becomes harder. In our view, the way to beat the herd is to look for funds that stand out in terms of the approach as well as the narrative.

For example, that might be a commercial property fund that invests in care homes, assisted living and key worker accommodation. Or a clean energy infrastructure fund whose long-standing commitment to wind and solar projects puts them in pole position to enable blue-chips to meet their carbon reduction targets now.

For private capital particularly, such investments often have the added benefit of being asset-backed, generating stable cash flows and/or are uncorrelated to other parts of the investment market, smoothing out volatility in portfolios and driving returns.

Green bonds may have been around for decades, but what’s new here is the idea of incorporating eco and ethical ideas into a whole investment ethos, plus the sheer power of the impetus that is driving it forward. Its effects will be far-reaching. For example, ESG is likely to impact the alternative assets space just as much as mainstream equities, with almost two-thirds of investors saying it will become a more integral part of investment strategy, according to recent research by Preqin .

Driven mainly (but not solely) by the younger generation, backed up by intensifying political will, regulatory might and media scrutiny, the pace of change is accelerating and a growth market is rapidly unfolding. Investors should select carefully and critically: if they do, they can look after their portfolios and the planet at the same time.

 Russell O'Connor
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