The Performance of Sustainable Investing: Impact and Returns (2024)

The Trillion Dollar Question

It may sound like hyperbole, but the question of how sustainable investments perform is actually more than a trillion-dollar question. The Global Sustainable Investment Alliance estimates that over $35 trillion[1]of professionally managed assets incorporate sustainable investment criteria. That fact alone almost answers the question. We doubt that many investors would put that much money at risk of underperformance. But there might be a whole host of investors in that group that expect to outperform. So, will sustainable investments give higher returns, or perhaps provide lower risk? We look at what the research shows, but first we examine the options available to the sustainable investor.

The Financial Returns of Sustainable Investing

Many investors remain confused about what to expect in terms of financial returns from sustainable investing. The money management industry does not shy away from claiming that sustainable investing offers higher returns and lower risk, while saving the planet. The marketing sounds great, but the reality is somewhat different.

The reality is that when investing you have a choice, because the type of sustainable investing you choose has a large impact on both your risk and your returns. In our earlier article we defined the three major forms of sustainable investing;

The Financial Returns of Impact Investing

Most impact investing requires putting your capital into private equity or private debt, or even individual projects. Financial returns in private markets can be extreme. Losing all of your capital, or making 10 times your investment, are both possible. Some impact funds that focus in areas like microfinance and affordable housing attempt to produce less volatile returns, but in private markets there are far more risks to consider. Private investments are illiquid, lack the investor protections of public offerings, and often go to newer, untested enterprises. The impact investor is likely willing to accept these risks as they are seeking impact over financial returns in the first place.

The Financial Returns of Socially Responsible Investing

SRI investors seek to balance the pursuit of financial return with the incorporation of their values. For example, an SRI investor might exclude tobacco, gaming, alcohol, and gun company stocks regardless of their return potential. If the investor ends up excluding many stocks, or even whole industries, their portfolios are less diversified and can underperform. Historically, SRI funds have done just that. However, SRI investors might be willing to accept lower financial returns to match their values. If you have unfortunately had cancer in your family, the fact that tobacco stocks have had high returns may not be enough to convince you to hold them.

The Financial Returns of ESG Investing

ESG investing is different from the preceding categories. Most modern ESG strategies are not based on what is individually important to the investor. Instead, they are about what is important to the investments—companies are selected based on how they are dealing with the environmental, social, and governance issues most likely to affect them financially.

There are ESG strategies built to deliver returns close to a market benchmark. Many ESG index funds and ETFs do just that. This makes ESG an option for far more investment applications. Investors, from large pension plans to individuals, that rely on their capital to meet future obligations often prefer ESG as it can be designed to deliver performance similar to conventional investments.

An ESG investor can also choose a strategy with more focus, perhaps investing in only sustainability leaders. Such funds tend to have more variable performance. We are going to take a deeper look at what drives performance within the ESG investment universe next.

Examining the Research on the Performance of ESG Investing

Academics have responded to the demand for ESG by publishing countless studies on ESG performance. But all these studies lack a critical ingredient that evidence-based investors crave – the statistical validity that comes with decades and decades of data. To make strong statistical inferences from stock market data, we prefer to have 60, 80, even 100 years of data to examine. Those long run performance histories are what give us confidence that stocks have higher average returns than bonds. And that bonds can, over the long run, beat inflation. Technically, ESG investing is less than twenty years old as the term was only coined in 2005. Unfortunately, we do not have those long historical returns for ESG.

We cannot say whether ESG portfolios will outperform or underperform conventional portfolios because we do not have the data to prove it. So, we turn to economic theory to understand what might happen. All those academic studies on ESG may not have been able to give us much data, but they have outlined the issues quite clearly.
Arguments for why ESG portfolios will outperform include:

Lower Risk – High ESG stocks produce less emissions and so might pay less in future carbon taxes. They also face fewer product recalls, lawsuits, environmental fines, labor issues, etc.

Innovation Premium – Companies working on the cutting edge of sustainability will develop the new products and processes we will use in the future as we transition to a low carbon economy.

Momentum – High ESG stocks’ prices will rise because more and more investors are shifting capital to high ESG stocks and away from low ESG stocks.
Arguments for why ESG portfolios will underperform include:

Early sustainable funds were built mainly on an SRI approach, and many suffered from the drawbacks outlined directly above. Perhaps in an attempt to satisfy as many potential investors as possible, they excluded too many companies and even whole industries, and bought only well liked and high-priced stocks. They were undiversified and charged high fees. Underperformance was common. Some commentators came to the conclusion that all sustainable investing underperforms. But a closer reading of the research gives guidance on what methods contribute to performance and which detract.

MASECO’s Approach

We build portfolios that can take advantage of the positive potential of ESG while minimising the drawbacks. We focus on what we can control. We make sure all our portfolios, both conventional and ESG, have broad diversification and competitive fees. And by tilting our portfolios to firms with high cost of capital, including small and value stocks, we make sure our portfolios are not just holding high priced stocks.

The research shows that it is not necessary to underperform when investing for sustainability. Whether one is investing in individual stocks, indices, or funds, an investor can achieve market performance or better. Investors who want sustainable investing with good performance can do so provided they act with care. They need only to abide by the fundamentals of investing that the successful institutional investors subscribe to.

If you are interested in learning more about our sustainable investment solutions, we encourage you to speak to your financial advisor. We can build a portfolio that will help achieve your financial goals and reflect your values simultaneously.

[1]https://www.bloomberg.com/news/articles/2021-08-18/-35-trillion-in-sustainability-funds-does-it-do-any-good?leadSource=uverify%20wall

This document is intended for the recipient only. It may not be copied, forwarded or otherwise distributed, in whole or in part, to any other party. This is an article was produced for MASECO by Vert Education and Consulting.

This document is intended for clients or prospective clients of MASECO LLP. It is for the use of the recipient only and may not be forwarded, copied or distributed, in whole or in part, without our prior written consent.