Recent Morningstar data reveals that 85% of SFDR Article 9 Global Equity funds have some degree of ‘Growth’ bias. We believe this bias is partly driven by the immaturity of the space and the approach to defining ‘sustainable’ investments.
More recently, oil has continued to soar, inflation has proved to be far from transitory and interest rates have risen sharply. The materially overweight ‘Growth’ sustainable and impact fund sector has come under significant performance pressure.
According to the Morningstar data, sustainable strategies have underperformed the MSCI ACWI by an average of 7.9% with 75% of this peer group underperforming from end January 2021 to end March 2022.
But sustainable investing does not always have to mean a bias to ‘growth’ or compromising on quality or valuation. The earlier origins of ‘sustainable’ investing placed great emphasis on lower negative, particularly environmental, impact as the primary focus. Although the industry is moving towards a positive impact approach in supporting and transitioning to a more sustainable world, many funds have not caught up.
The earlier mindset was better suited to Growth investors and as the sector continues to mature, the range of sustainable strategies will broaden and the current investment biases will decline.
Our definition of ‘sustainable’ is companies that have a high total positive impact, balanced fairly across all stakeholders. ‘ESG’ or ‘Sustainability’ is highly subjective; however, there remains a degree of crowding into certain stocks. For instance, there are several sustainably managed pharmaceutical companies that develop treatments for crippling diseases, approach ‘access’ proactively, and price treatments responsibly.
However, some investors focus more exclusively on financial risk to define sustainability and deem the reputational and legal risks that are more pronounced within the pharma space as too high.
Not enough weight is placed on the positive impact of access strategies in reaching lower income patients in emerging economies. Access strategies include direct donations of treatments and the licensing of patented treatments to generic manufacturers to low-income countries, so the treatments can be produced and sold at a vastly reduced price point.
Among pharmaceutical companies, there are various high-quality mature businesses, at attractive valuations with high total positive impact.
This segment is underrepresented in our view, relative to our assessment of its sustainability. In the absence of more publicly reported data and a better understanding across the investment management industry of these businesses’ positive global impact on human life, it is likely that the sector remains underrepresented relative to other segments such as Clean Tech.
‘Impact at any price’ and a focus on valuation in sustainable investing is more important than ever. We have seen bubbles inflate and burst, as different pockets of ESG have garnered attention. Clearly, being solely good on ESG does not guarantee strong returns. A company that is positively aligned with climate megatrends and manages the climate impact of its operations diligently will experience greater tailwinds than a less advanced company.
But that does not mean that an investment in such a company will generate better returns – it ultimately depends on the price paid. Should ‘good ESG’ not be appropriately priced in, an investment has the potential to outperform. However, if these ‘ESG’ opportunities attracted so much attention, that valuation becomes entirely detached from fundamentals, this would not make for an attractive long-term investment.
Take for example a well-known wind turbine manufacturer that has a long track record of low returns on capital, profitability and management missteps. Without doubt, the company will experience very strong tailwinds, as offshore wind demand in particular continues to accelerate. However, the company can be relied upon to capitalise on the opportunity. Investors who chased ESG or Impact at any price with little regard for valuation within sectors such as Clean Energy, experienced material headwinds to investment performance when prices reverted to intrinsic value.
Certainly, there is a place for higher growth investments, such as early stage businesses developing technologies that enable financial inclusion. We find that some of these companies act responsibly, and the valuation level is underpinned fundamentally.
However, there is also a place for mature companies. For example, GlaxoSmithKline supports access to treatments that are saving lives, but is not a very high growth business. Indeed, these companies will often have a more sophisticated approach to access. Certain companies that have risen through the development of COVID vaccines have for example struggled to balance their responsibilities to support access in lower income economies as a result of having less developed resources for supporting access.
More established and mature businesses that already have positive impact are also better positioned to report on this, which clarifies the impact of the underlying holdings within a portfolio. In contrast, earlier stage, higher growth companies might not even have any current impact (and more so the prospect of delivering impact in the future) or the capacity to report on it.
The current bias towards ‘Growth’ is a function of the maturity of the ‘sustainable’ investing space and, as the industry evolves towards an increased focus on the positive impact of business, we expect these investment biases to decline.
Maybe it is time for a different way to invest sustainably…one that provides for investors seeking a more sustainable approach without being forced to take a bet on ‘Growth’ or compromise on valuation discipline.
Alex Rowe manages the Global Sustainable Equity fund at Nomura Asset Management