What you need to know
- Market environment: whilst past performance is not a reliable indicator of future returns, ESG equity strategies have proven their worth over the long term. In the short term, however, they can underperform less ESG strategies, as seen in 2022.
- Philosophy: we take a principle-based approach to ESG, which means we see ESG as an investment opportunity, not a constraint.
- Toolkit: we recognise that ESG is not binary. We describe the diversity of our investment approach as a toolkit, which contains strategies such as leaders, improvers, themes and dedicated assets.
- Asset allocation: we integrate ESG in our asset allocation process from asset class forecasts to sub-asset class exposure.
- Instrument selection: innovation inspires our instrument selection.
Our ESG investment approach starts with an understanding of the broader market environment. This contextualises our investment philosophy, toolkit, approach to asset allocation and instrument selection (figure 1).
Growing Investor Interest
ESG assets have increased rapidly in recent years. According to Morningstar, as of December 2021, global ESG assets stood at USD 2.74 trillion1
, almost triple the December 2018 figure. The pace of growth and innovation continues to accelerate, as the number of sustainable funds launched in Q4 2021 is almost double that of Q1 2019.
Investor interest is growing, especially following the global pandemic. A survey of families, foundations and individuals found that they increased their portfolio allocations to ESG investing during the pandemic to an average of 36% in 2020, up from 20% in 20192
Whilst past performance is not a reliable indicator of future returns, over long time horizons, ESG indices have generally outperformed their conventional counterparts. The commonly referenced MSCI World Socially Responsible Investment (SRI) Index has outperformed its conventional counterpart, the MSCI World Index, by around 1% per annum on average over the past 10 and 15 years. In the last six calendar years3
(figure 2), the pace of outperformance had picked up, particularly thanks to 2020 and 2021. For example, according to Morningstar, 66% of US sustainable funds outperformed conventional market indices in 20214
2022 has not started with the same momentum as conventional markets have been narrowly led by a small number of sectors, such as energy and defence, which have performed strongly and do not carry much weighting in ESG indices. Such short-term performance deviations will happen from time to time; however, we believe the superior characteristics of ESG strategies will have the potential to be rewarded in the long run.
The growth of ESG finance has triggered a regulatory response, which will likely encourage more flows into sustainable assets. For example, the European Union Sustainable Finance Strategy aims to reorient capital flows to finance sustainable growth. The UK’s ESG investing roadmap seeks to green the UK financial system and align it with a net-zero commitment. Meanwhile, the Securities and Exchange Commission has proposed climate-related disclosures for US companies, which will provide more consistent corporate disclosure for investors.
ESG investing is at the core of our investment philosophy and our default investment proposition. We believe that understanding material environmental, social and governance (ESG) factors improves the investment decision-making process and can lead to better returns. This is supported by several academic studies, which show evidence of boosting investment returns when incorporating ESG factors5
. ESG investing can also create value for investors beyond investment performance as they can align their own values and beliefs with their investments6
1Global Sustainable Fund Flows: Q4 2021 in Review. Morningstar Manager Research. 31 January 2022.
2Investing for Global Impact: A power for good 2021. https://privatebank.barclays.com/content/dam/privatebank-barclays-com/en-gb/private-bank/documents/campaign/ifgi/investing-for-global-impact-2021.pdf
5Gunnar Friede, Timo Busch & Alexander Bassen (2015) ESG and financial performance: aggregated evidence from more than 2000 empirical studies, Journal of Sustainable Finance & Investment, 5:4, 210-233, DOI: 10.1080/20430795.2015.1118917
When pursuing a ESG investment strategy, we predominantly follow a principle-based philosophy as opposed to a rules-based philosophy (figure 3). Principle-based philosophies view sustainability as a toolkit that can enhance the investment process. Investors seek to embed ESG insights into their investment approach in order to expand the dataset used for investment decisions. This can lead to more informed choices and extended opportunities.
On the contrary, rules-based philosophies treat ESG as a series of check boxes. Investments must “pass” the rules and tests in order to be investible. Adopters of this philosophy typically rely on numerous exclusions, which restricts the investment universe and can lead to reduced investment opportunities.
We recognise that ESG is not binary and a variety of investment strategies can be created to exploit ESG investment potential, each with different investment characteristics. We describe the diversity of our investment approach as a toolkit, which contains strategies such as leaders, improvers, themes and dedicated assets (figure 4). Each approach provides a framework for the integration of sustainability factors at security level and can be implemented either standalone or in support of portfolio construction and risk management.
seek to invest in companies with the strongest ESG practices. Investors deploying leader strategies expect fewer adverse events – such as accounting scandals. They believe that a holistic approach to business will generate improved cash flows through factors such as increased customer loyalty, greater employee productivity and collaborative supply chain partners, ultimately leading to better financial performance.
seek to invest in companies that are exhibiting positive momentum in their ESG practices. Investors using improver strategies expect sustainability improvements to correlate to, or cause, improved operational performance. By identifying momentum ahead of other investors, they believe investee companies will deliver improved cash flows and may re-rate to a higher equity multiple, or a tighter credit spread. Investors may attempt to catalyse the improvement through active ownership; engaging company management through dialogue and voting in order to improve business practices and financial performance.
seeks to identify companies that are well-positioned to take advantage of significant secular growth trends currently underappreciated by the wider market. Investors deploying thematic strategies expect that companies exposed to these trends will have the potential to grow their revenues and cash flows faster than their competitors, commanding higher valuation multiples and potentially leading to attractive returns for investors over a multi-year time horizon.
investors seek to invest in financial instruments that are explicitly designed with ESG as a defining characteristic. Dedicated assets are either close replications of a conventional sub-asset class, such as multilateral development bank debt having similar financial characteristics as AAA-rated government debt, or they offer significant decorrelation benefits with unique exposure, such as microcredit.
These approaches harness various factor tilts (figure 5). When used together multiple risk premia can be harvested and sector and factor biases can be partially mitigated. For example, the popular leader approach often creates large capitalisation and quality biases. Building portfolios with the improver approach can enable a portfolio to partially capture the value factor. In some cases when improvement is linked with active ownership, improver strategies may also exhibit an emerging market and/or mid-cap tilt, which also provides additional diversification benefits. Themes often favour companies that are smaller and have higher growth, while dedicated assets include both close replications of conventional sub-asset classes as well as unique assets that offer significant decorrelation.
A robust ESG investment strategy involves incorporating ESG throughout the asset allocation process. As a first step we incorporate ESG considerations into our economic forecasts that in turn guide our capital markets assumptions – our long-term views on asset class risks and returns.
As a second step we make informed decisions about which sub-asset classes should comprise our multi-asset portfolios. Due to a combination of investment and ESG considerations we opt not to allocate to commodities, with the exception of gold.
As a third step we utilise our ESG toolkit and knowledge of the market environment to determine the optimal ESG representation of each sub-asset class (figure 6).
We believe that ESG markets are deep and liquid enough to fully replicate a globally diversified asset allocation portfolio using ESG assets. For example, conventional gold can be ESG represented by recycled gold. Recycled gold
has the same financial characteristics as conventional gold but exhibits a carbon footprint that is 20 times lower7
When selecting instruments to populate the asset allocation framework, we ensure that each one meets our financial and ESG expectations.
When investing directly in bonds and equities, we embed ESG in every step of the process. We apply selected exclusions to ensure minimum responsible standards are met when defining the investment universe. Material ESG factors are integrated into fundamental research to enrich idea generation and improve the accuracy of valuations. Portfolio modelling incorporates ESG principles, seeking to improve the risk/return profile. Finally, we fulfil our fiduciary duty and further improve portfolio potential risk adjusted returns through making informed voting decisions and engage with company management.
When investing in third-party funds, we work closely with external fund managers to communicate our ESG investment approach and expectations. Our dedicated fund selection team assess the fund’s elements such as its objectives, holdings and the fund manager’s capabilities, resources and the transparency of reporting. This process delivers the choice of funds that meet our requirements for both financial performance and ESG.
Active ownership, which includes voting and engagement activities, forms a crucial element of ESG investment by influencing change at the companies and external fund managers. Our 2021 active ownership activities are summarised in our Active Ownership Report
We operate with open architecture to ensure we capture the full talents of the investment industry, regardless of firm affiliation. Where solutions are not yet available, innovation inspires our instrument selection.
ESG investing is at the core of our investment philosophy and our default investment proposition. Our ESG investment approach is an investment philosophy that seeks competitive risk-adjusted financial returns while also doing good for people and the planet. We start with an understanding of the broader market environment, which contextualises our opportunity-focused investment philosophy and our diverse return-seeking toolkit. We are then able to incorporate ESG throughout the asset allocation process and drive our ESG approach into portfolios via innovative instrument selection.
The information contained in this article is defined as non-independent research because it has not been prepared in accordance with the legal requirements designed to promote the independence of investment research, including any prohibition on dealing ahead of the dissemination of this information.
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Information correct as at 02 May 2022.
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