Why sustainability stacks up

You have no doubt heard about increasing investor interest in sustainability and the growing funds under management in sustainable investment strategies in Australia.

But what is it all about – and can you be sure that performance goals are met when adopting a sustainable investment approach?

What do we mean by sustainable investing?

Sustainable investments aren’t new – and sustainable funds have been around since the 1970s.

Sustainable investing can be approached in many different ways. A traditional ethical approach will screen specific unfavourable sectors however, increasingly managers are using sustainability criteria to actively select, rather than exclude, investments.

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At BT, when we talk about sustainable investing we are referring to any strategy that, at a minimum,  includes the integration of environmental, social or governance (ESG) factors alongside traditional measures of financial performance in the investment process. This is known as ESG integration.

It also includes a focus on the stewardship of asset ownership, including engagement with companies on ESG matters and through proxy voting.

In short, a sustainable investment strategy will focus on having a deeper understanding of the investment, over both the long and short term, by considering ‘how’ companies are making money and not just the money they make. 

Does it work?

While your clients may be drawn to sustainable opportunities to ‘do good’ or ensure that their investments are in companies that align with their values, these aren’t the only reasons to consider sustainable investing.

Research shows investments that adopt a sustainable approach can deliver comparable performance. And in some areas sustainable investments outperform more traditional investment approaches.

We know Modern Portfolio Theory suggests limiting the investment universe, especially because of non-financial factors, results in a less-efficient portfolio, sacrificing diversification and increasing either volatility or risk, or both.  

However history has shown us the potential that ESG issues have to affect the risk and return of investments.

Therefore if we can consider what types of ESG risks a company faces and how well equipped it is to manage these types of risks, we can factor this into our investment decisions.

This is the case for sustainable investing; by looking at a broader range of non-financial information we can better understand the overall quality of an investment.

And it works. The oldest sustainable index, MSCI’s KLD 400, was created in the 1990s, and consists of 400 companies selected from the MSCI USA IMI Index with high ESG ratings while excluding companies whose products may have negative social or environmental impacts.

Chart 1: MSCI KLD 400 since inception v S&P 500

Source: Morningstar Direct

Chart one shows the MSCI KLD 400 index since inception against the S&P 500. Whilst sustainability criteria will add value in some periods and subtract in others, over the long term the KLD 400 has outperformed the S&P 500.

According to Morningstar research 16 out of 20 equity indices in Morningstar’s Global Sustainability Index family have beaten the performance of their non-ESG equivalent over their lifespan.

The world’s biggest investor, BlackRock, notes that ESG can be implemented across most asset classes while maintaining risk-adjusted returns.

Interestingly Blackrock has looked beyond equities into other portfolios and have found, for example, that it’s possible to build an ESG focused investment grade bond portfolio with results comparable to traditional ones.

How do you approach sustainable investing?  

Today sustainable investments make up 4.5 per cent of Australia’s total assets under management, and has grown by 26 per cent over the 12 months to December 31, 2016.

There are plenty of options for sustainable equity funds from well-known managers that offer exposure to different markets. And while the options in other classes may be more limited, it is a rapidly growing area.

The name of the fund can indicate if it’s a specific sustainable investment, and a little bit of research will help you understand more about the fund’s strategy.

Depending on how and where this fits within a portfolio, you may consider a fund with a tilt to companies with superior sustainability profiles or a fund that focusses on best-in-class selection in certain markets.

You may also want to consider if there are any industries or sectors that your client would like to exclude. Traditional exclusions like tobacco and controversial weapons are very common among sustainability funds, but funds are emerging that also exclude emerging issues - for example exposure to fossil fuels.

Tools like the Morningstar Sustainability Rating, available on the BT Panorama platform, can provide advisers and investors with a measure of how well the companies in a fund’s portfolio are managing material ESG risks and opportunities.

The Responsible Investment Association of Australasia (RIAA) shows that 63 per cent of Australians expect their advisers to incorporate their values or consider the societal or environmental implications of particular investments.

Sustainable investing is here to stay, and as we get more long-term data on the performance of sustainably themed investments it’s clear that there is an opportunity for clients to build ESG into many traditional portfolios while maintaining performance expectations.

Emma Pringle is Head of Customer Governance and Sustainability, BT Financial Group