End of Week Notes
4 Things About Sustainable Investing to Keep in Mind in 2022
And 4 ways that it’s having a positive impact on the world
Sustainable investing had another successful year of growth, performance, and influence in 2021. Global sustainable funds attracted record inflows in just the first three quarters of the year, while their overall assets under management approached $4 trillion. Performance remained strong. Based on year-to-date returns as of mid-December, 56% of sustainable funds ranked in the top half of their respective Morningstar Categories, and only 44% ranked in the bottom half. Sustainability concerns, particularly around the climate crisis, are on the agendas of regulators around the world and have gained influence in Washington with the new administration.
If you are one of the many individual investors or financial advisors considering adding a sustainability lens to your investments in 2022, here are four things to keep in mind about sustainable investing:
1) Sustainable investing is not just one thing: It represents a range of specific investment approaches
Sustainable investing is not a singular approach but instead represents a range of methods that investors can use to generate competitive investment returns while helping generate positive outcomes for people and planet. Our Sustainable-Investing Framework describes six distinct approaches to investing with sustainability in mind. Any given sustainable fund may use one or a combination of these approaches. In addition, these approaches are used in conjunction with standard investment practices that emphasize things like style, quality, or momentum.
What does this mean for you? It’s important to take the time to understand what’s under the hood. Do not assume that funds with names that include terms like “Sustainable” and “ESG” are identical investments. A good example is the treatment of fossil fuel exposure in sustainable funds. Some funds avoid such exposure altogether. Others have “best-in-class” environmental, social, and governance standards for fossil fuel companies to make it into their portfolios. Many of the funds that do include fossil fuel companies have ramped up their engagement with those companies to press them to reduce emissions. Some fixed-income funds may purchase green bonds issued by fossil fuel companies to help them finance renewable energy projects. And funds focused on renewable energy may have a lot of exposure to fossil fuel companies that are making major investments in renewables.
So, it’s important to look under the hood to understand the details of any sustainable fund you are considering, particularly now that there are more than 500 open-end and exchanged-traded sustainable funds available to U.S. investors. A lot of the claims of “greenwashing” really have to do with a mismatch between investor expectations and a fund’s specific sustainable-investing approach. Funds can do a better job of informing investors about exactly which approach or approaches to sustainable investing they employ. Because of the urgency of the climate crisis, all sustainable funds should publish a Statement on Climate Change indicating how they are addressing climate-related issues.
2) Sustainable investing continues to evolve and innovate
Sustainable investing is connected to bigger-picture global changes. We are moving from an era in which most investors were OK with public companies making money for them while also generating negative social or environmental consequences, to one in which investors increasingly expect companies to make money while avoiding such costs or generating positive impacts. Rather than focusing solely on how ESG risks may affect an investment, more sustainable investments are also assessing the impact of an investment on people and planet. Innovations include funds focusing on improving corporate behavior through deep engagement and proxy voting, and funds starting to apply net-zero criteria to their investment selections.
3) Sustainable investing should deliver competitive investment performance
Sustainable investments should be expected to generate competitive long-term performance. Sustainable investors should neither expect to always outperform nor to always underperform, but they should expect investment returns that are competitive with those of conventional investments. It has been hard to bust the myth that sustainable investments underperform. That certainly hasn’t been the case during the past few years when, on the whole, sustainable funds have performed better than conventional funds. Keep in mind that returns of sustainable funds are not determined solely by the use of sustainability criteria, but also by other investment criteria employed by fund managers, so it’s hard to sort out the relative effects of each on performance. That’s why I recommend evaluating a sustainable fund’s overall performance holistically and compare it with that of all funds that invest from the same broad asset class or investment category.
4) Sustainable investments are primarily returns-focused, but they can have broader impact
Sustainable investing is primarily about investing, not social or environmental activism, but it does have impact on the world. You may be attracted to sustainable investing because of your own social or environmental concerns, but the main focus of a sustainable fund is to generate competitive investment returns to help you reach your financial goals. That said, by making a sustainable investment, you are having more impact with your money than if you invested in a conventional way.
Here are four ways that sustainable investments are helping to generate impactful outcomes for people and planet:
- The overall growth of sustainable investing is leading companies to address material ESG issues they may have overlooked or not considered relevant. Today, few companies want to be excluded or underweight in ESG indexes, or otherwise singled out as poor ESG performers. They know it reflects poorly on broader stakeholder perceptions of the company, which affects reputation, brand, and regulatory decisions. Sustainable investors are spurring companies to address issues that impact workers, customers, communities, and climate. Investing used to reinforce the idea of shareholder primacy; today, sustainable investing is helping enable the transition toward stakeholder capitalism.
- Sustainable investors are having a more-direct impact by ramping up what we call “active ownership” activities — directly engaging with companies on sustainability issues, proposing shareholder resolutions, and supporting such resolutions via their proxy voting. Just this past year at U.S. public companies, 35 shareholder resolutions proposed by sustainable investors attracted a majority of shares voted; 75 attracted at least 40% of votes. That is a sea change from the recent past, when it was considered a victory for a shareholder proposal to generate 10% of the vote. These activities help companies understand best ESG practices, underscore how strongly investors feel about ESG issues, help companies devise solutions to ESG problems they face, and place new issues on the agenda. This year, for example, investors requested racial equity audits be performed at eight major companies, including Citigroup ©, Johnson & Johnson (JNJ), and Oracle (ORCL). These proposals averaged about 35% of the vote. The popularity of such measures makes boards of directors sit up and consider incorporating these views into company policy and strategy.
- Sustainable investors are channeling capital to companies making goods and services that will fuel a more sustainable economy and financing projects through green bonds and other sustainability-focused bonds that are intended to have positive impacts on climate or other environmental and social issues.
- Just as the overall growth in the field is leading companies to address material ESG issues, a growing emphasis on impact has started focusing attention on the impacts of companies on the world. Underlying this is the idea that public companies ought to have a mission that contributes positively to the world and to minimize their negative impacts. Investors and, in some cases, companies themselves are using the United Nations’ Sustainable Development Goals as a framework for evaluating impact.
Having reasonable expectations for any type of investment is important for investor success. For sustainable investing, keep in mind that it includes a range of still-evolving approaches, so it’s important to look under the hood of any sustainable fund to make sure it aligns with your expectations. Keep in mind, too, that sustainable investments are primarily performance-driven and should be held to the same reasonable performance standards you expect from any investment. And while impact may be secondary to performance, sustainable investments are achieving broader impact in several ways. I expect to see more innovation on the impact dimension in 2022.
This post was originally published at Morningstar.com.
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