I recently traveled from the US to Europe to learn about the major market differences in sustainable investing. For context, investors long rooted in sustainable investing practices have viewed the general US market as lagging compared to Europe. As it pertains to values-based investing, I agree. However, the US has embraced ESG integration in a very sophisticated and pioneering way as it relates to risk mitigation.
While I learned about the various regional drivers and motivations for sustainable investing in Europe, I was struck by the fact that we’re all embracing similar new global trends in sustainable investing and building off of each other’s regional drivers and best practices. For example, in the US I’m now having far more conversations around norms and values-based screening as investors try to appeal more to the retail segment.
Although Europe is characterized by a traditionally segmented market as it relates to sustainable investing, everywhere I went I was having very similar conversations to the ones I have in the US on a daily basis. This was especially true as it pertains to the integration of sustainability data into structured products, risk premia quant products, the creation of ETFs and the use of sustainability data to report on portfolios. This realization really drove home the message that there are so many ways for an investor to pursue sustainable investing.
The gap between our global interpretations of sustainable investing is narrowing and asset managers currently seem to be more focused on developing and innovating new ways of leveraging this information. Rather than look at which sustainability approaches are “the best”, maybe we should consider how all investors can best capture all of the approaches and apply them in different ways across the asset allocation mix.
Therefore, on both sides of the Atlantic, I see three major trends in the evolution of sustainable investing practices as it relates to the broader application of sustainability research and data:
- More data, more tools and a broader acceptance are leading to a proliferation of ways to use sustainability research and data;
- An increase in usage across strategies, evolving from predominantly fundamental equity analysis to growth in fixed income, passive and quant solutions. This growth is also expanding to different parts of the investment cycle, evolving from screening, security valuation and portfolio construction to further growth in portfolio analysis and reporting;
- Better understanding around the differences in sustainable investing approaches, from negative avoidance to ESG integration and positive impact.
I started thinking about this from an implementation perspective, which got me thinking about how this would translate into my own portfolio.
As an industry, we’ve spent the last few years defining the different terms associated with sustainable investing – and I think we’ve made progress. However, what I think is a greater feat is the shift in thinking about sustainability as an all-encompassing term to understanding that it’s an umbrella of approaches that each allow for distinct forms of implementation. The various ways of employing sustainable investing approaches can capture different exposures for a given portfolio, including both intentionality and risk mitigation.
For example, when investing in a sustainability portfolio, as an investor, do I want a portfolio with diversified, market-based characteristics? Or do I want to invest in companies that promote access to nutrition? Would I rather invest in portfolios that minimize exposures to small arms? Well I want it all! But I don’t want them to be mixed up; I want them each for the value-add they bring me.
I want the larger portion of my asset allocation to be in ESG versions of my core diversified portfolios that invest in companies across all sectors, capturing companies that are mitigating their operational ESG risks. After all, as a prudent investor, I still need to think about my risk return profile to fulfil my personal financial goals. However, I also want a smaller portion of my assets to be allocated to portfolios that are aligned to my values and the issues I care about. For example, portfolios that focus on access to nutrition, because I believe that fosters a healthy culture; and through my investments I want to avoid and discourage companies that produce and distribute small arms to be consistent with my ethical values. For the latter two, I hope it translates into alpha, but regardless, I want those values to be reflected in my investments.
I want these approaches to be employed across the strategies I enlist in my asset allocation mix, instead of thinking about sustainability as an isolated concept. For example, if I believe in using a passive strategy for the more efficient markets, then I’d like to employ a passive sustainability vehicle. More generally, if I’m looking for a portfolio as part of my core allocation, having sustainable versions of funds that I am already familiar with is quite compelling as it captures the best-in-class companies from an ESG perspective, reduces exposures to controversial areas, while still delivering market returns.
For my fixed income allocation, where I’m particularly concerned with default risk and the impact to my interest payouts, I might consider the concept of sustainability through both the lens of risk and use of proceeds, i.e. picking issuers that are mitigating their ESG risks and selecting issuances that create a positive impact through the use of proceeds such as green bonds.
Even for my alternatives, incorporating sustainable investing into my real estate and infrastructure allocation can be very additive as those areas can be highly vulnerable to ESG issues. I could also look for alpha approaches related to water, gender, the SDGs or other thematic investments that have the potential of creating a positive impact.
I can go on further about the incorporation of sustainability data into quant strategies, EM strategies, etc… but the point is that I think various sustainability elements can be captured appropriately in almost any strategy. It’s important to think of it this way, because most investors still think in terms of, and make decisions based on some version of Modern Portfolio Theory.
Just as importantly, I want to better understand the sustainability characteristics of my portfolio. It’s increasingly important to understand how sustainability is contributing to the performance and risk of your portfolio, as well as understanding what it’s exposed to and what it is capturing compared to the benchmark.
Overall, I would love for my whole portfolio to be exposed to sustainable investing; and I think this is very possible, as long as the various strategies and approaches are employed in the most appropriate ways.
I believe that the tools and information that allow investors to do this are now finally available. Signals from the Morningstar Sustainability Rating for Funds provide insight into the ESG risks of a portfolio. There are also an increasing number of sustainability index products and mutual funds that allow for more sustainability fund options. In addition, tools such as Morningstar Direct, FactSet and Bloomberg enable fund managers to more effectively report on sustainability features to help investors understand how ESG considerations are contributing to their portfolios.
So, whether I’m investing in positive products, positive corporate behaviors or avoiding negative exposures, I’m still looking to mobilize asset flows to the companies that I feel good about and are contributing to the sustainability of this world. And while I acknowledge that the regional motivations still exist, rather than thinking about geographic differences, I now find it exciting to see the whole market growing in its diversity of options; a sign that the field is maturing, infusing a sense of collaboration to drive further enhancement, growth and strength for sustainable investing.
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