Every so often, we see reports confirming that we don’t need to sacrifice financial returns for our sustainability preferences.
We got this during the Covid-19 lockdowns, when all funds that were overweight technology hugely outperformed those with exposure to the “old world” of oil and gas, industrials and airlines.
Then, it all went quiet.
As the world opened up again, and interest rates started to rise, we saw a swing of the pendulum favour the dividend payers and punish those that were either promising jam tomorrow or that rely heavily on advertising and consumer spending just as they were being forced to tighten their belts.
All this showed that, under different economic conditions, either growth (technology) or value (dividend-paying plodders) might be more in favour; something we probably always knew anyway. So sustainable investment is no less prone to cyclicality than any other investment style or theme.
Prior to “ESG” or “sustainability” being the driver for values-based investing, the only funds that were prepared to go out on the “values-based investing” limb were called ethical, and relied on exclusion policies to set themselves apart, avoiding the “sin stocks” of alcohol, tobacco, gambling, pornography, nuclear power and military weapons.
That list now looks a bit out-dated, with nuclear power included in the EU’s green taxonomy and indications that the UK will follow suit.
Even the most basic knowledge of portfolio theory will tell you that the more you restrict your investment universe, the more risk you need to take for the same potential return. In other words, you might outperform over-selected time periods, but you are likely to encounter more volatility as well.
Impact of upcoming regulation
Sustainable investment has moved on from the blunt tool of only using exclusions, but I wonder how many funds that promote themselves as sustainable are willing to have exposure to the oil and gas sector, for example, despite the Financial Conduct Authority’s (FCA’s) proposals in its last consultation paper to recognise the importance of companies making the transition to a more sustainable business model.
This issue impacts two current hot topics: the FCA’s Sustainability Disclosure Requirements (SDR) and the new Consumer Duty. The former (SDR) is expected to proceed to a policy statement and final rules by September, and proposes that sustainable funds disclose any “unexpected investments” to meet transparency requirements.
The latter (Consumer Duty) – which comes into full effect at the end of July – mandates product providers and distributors to recommend suitable products, communicate effectively with consumers, and avoid causing foreseeable harm.
Under the Consumer Duty, product providers and distributors need to ensure that products are only recommended to the right consumers, that all communications are designed to be understood by those consumers and that firms act to avoid causing foreseeable harm to consumers.
Combining that with the proposal in the SDR consultation for funds to disclose any “unexpected investments” in what is promoted as a sustainable fund, such as, perhaps, an oil major with a credible transition plan, and advisers run the risk of falling foul of the Consumer Duty if they don’t make clients aware of what they are investing in.
Knowing that performance by sustainable funds is as cyclical as any other style bias means you’d almost certainly be causing foreseeable harm if you avoid transitioning companies completely and don’t tell them about the higher potential volatility.
In addition to this – and due to changes to Mifid II that came into effect in the EU after the end of the Brexit transition (so they don’t apply in the UK) – advisers are now obliged to ask their clients about any sustainability preferences they may have and may only recommend investment products that meet those preferences. The Consumer Duty requires firms to “act to deliver good outcomes for retail customers”, which may or may not include any sustainability preferences the client may have.
Obviously, if a consumer has sustainability preferences, these must be taken into account, but there are as many different versions of such preferences as there are retail investors, so a real understanding of how a fund is managed and what impact this could have on its risk-return profile, as well as knowing the client and their attitude to risk, are imperative. If a client expresses a wish to avoid fossil fuels at all costs, then only funds that commit to exclude them can be included in the mix.
Increasing diversification
What’s crucial now is that we move away from this headline-driven performance comparisons between sustainable and non-sustainable funds over selective time periods.
Just as the active versus passive or growth versus value debates are nuanced, selecting the right fund for an investor requires considering a range of metrics, with sustainability preferences being one aspect. By focusing on the fund’s objectives, investment strategy, and aligning them with the investor’s goals, a more holistic approach to sustainable investing can be achieved.
Incorporating the Consumer Duty and embracing the upcoming SDR will enhance transparency and accountability in sustainable investing. Recognising that sustainable investments exhibit cyclicality, it is essential to educate clients about potential risks and align their financial objectives with the chosen investment strategy.
By diversifying sustainability strategies beyond exclusions and considering individual sustainability preferences, investors can be empowered to make informed decisions that align with their values and financial goals.