Increasingly more people realize that their sustainability concerns can be address through their investments. As more investors embark on the sustainable investing journey—learn what it is, why one pursues it, and how to do it—assets into sustainable funds will continue and investors will have more choices from which to construct sustainable investing portfolios.
Individuals and institutions are increasingly concerned about sustainability issues. A World Economic Forum survey from the fall of 2020 concluded that 79% of American respondents agreed with the following statement: “I want the world to change significantly and become more sustainable and equitable rather than returning to how it was before the COVID-19 crisis.” We take a look at the growth of investor interest in sustainable investing while answering some common questions about it.
What is Sustainable Investing
You may have heard various terms used to describe sustainable investing—socially responsible investing, ethical investing, impact investing, among others. Although each of these terms is relevant to specific financial industry actors, types of clients, investment strategies, or subsectors of activity, they fundamentally describe the same thing:
Investments made with the intention of generating a positive environmental, social, and governance (ESG) impact alongside a financial return.
Investors commonly use sustainable investing to pursue two overarching goals:
- To protect and enhance long-term financial value through addressing ESG risks or investing in solutions to solve environmental and social challenges.
- To protect, enhance, or otherwise positively impact the long-term health of the environment or society through expressing ESG values.
Some examples of ESG issues that may be considered in an investment strategy:
Environmental: Greenhouse gas emissions, energy management, and water and wastewater management.
Social: Access and affordability, labor relations, and diversity and inclusion.
Governance: Compensation and benefits, data security, and supply chain management.
Why Sustainable Investing?
Investors generally pursue sustainable investing strategies for two reasons:
- Fortify long-term performance. ESG issues can have a material impact on investment returns. When poorly managed, they can introduce risk into investments; when well-managed, they can produce financial benefits. Some investors consider ESG issues in their investment decision-making to enhance long-term risk-adjusted returns. Others see financial return-generating opportunity in investing in companies that produce solutions to environmental or social challenges.
- Express personal values. Some investors desire to help build a world based on positive ESG values—a sustainable world—and adopt investment strategies that align with those values.
Sustainable Investing Implementation Strategies
Investors typically reach these goals using any combination of three strategies:
- Aligning. Aligning their values with their investments to minimize exposure to companies or industries whose business practices conflict with their personal convictions.
- Integrating. Integrating ESG factors into investment decisions to identify and emphasize investments in companies or industries with positive ESG practices or that solve specific ESG challenges; and to limit exposure to those with poor ESG performance.
- Engaging. Engaging with portfolio companies and fund managers to encourage improvements in ESG performance and mitigate risks related to ESG, and to improve financial systems.
Strong Growth of US Sustainable Funds
As shown in Figure 1, sustainable investing mutual funds and exchange-traded funds (ETFs) continue to attract record flows from investors. ESG considerations are central to the investment process for these strategies and this commitment is indicated in the “principal investment strategies” section of their prospectus. As of December 31, 2020, assets grew 69% from the year before to $256 billion through the 381 distinct options available (compared to 140 options in 2009).
Sustainability Performance of US Sustainable Funds
Sustainable investing funds mostly outperformed in 2020, particularly equity funds. As shown in Figure 2, roughly two-thirds of all sustainable investing funds outperformed their peers (finishing in the top 2 quartiles), with only 12% in the bottom quartile.
In addition to assessing the investment performance of sustainable funds, it is also important to assess the sustainability performance of these funds to evaluate whether they are doing what they claim to be doing.
Morningstar’s Sustainability Rating, which is based on rolling up Sustainalytics’ company-level ESG Ratings, can be used as a proxy to identify funds that consider ESG factors. About three quarters of sustainable funds received the highest ratings, as compared with only one third of funds overall, illustrating significantly lower levels of ESG risk in their portfolios.
Another important, although often overlooked aspect of sustainable investing is how a fund engages with companies it owns through means including proxy voting in order to provide impact beyond financial return. Often called active ownership or stewardship, shareholder resolutions on proxy ballots often address sustainability issues. Data from 2020 illustrated a mixed bag, with most sustainable funds voting in support of key ESG issues, with large passive funds opposing most of the key votes.
Investor interest in sustainable investing has grown significantly over the last couple of years and we don’t expect that momentum to slow any time soon. Strong performance from sustainable funds in 2020 certainly played a role, but we think investors’ increased willingness to express their values through their investments may be a bigger part of the story, which is why we think the growth is—dare we say—sustainable.
Read previous editions of Weekly Market Commentary on lpl.com at News & Media.
Jeffrey Buchbinder, CFA, Equity Strategist, LPL Financial
Jason Hoody, CFA, Head of Investment Manager Research, LPL Financial
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