CIO Weekly - Sustainable Investment

CIO Weekly - Sustainable Investment

WHAT YOU NEED TO KNOW

SUSTAINABLE INVESTING DELIVERS
Sustainable investing has entered the mainstream. The
United Nation’s Principles of Responsible Investment has
collected over 2,300 investor signatures (including
Quintet’s) representing over USD 85 trillion in assets. It is
now pervasive on the regulatory agenda, particularly in
the EU, and individuals are seeking to align their wealth
to their values and lifestyle choices in order to create a
Richer Life.

The Covid-19 pandemic, global recession, and stock market decline have marked a significant test for sustainable investing – a test that it has passed with flying colours.
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INVESTMENT RETURNS

Sustainable investing is an investment philosophy. It posits that material environmental, social, and governance (ESG) factors will influence investment returns. Sustainable investors believe that understanding these dimensions improves the investment decision- making process. This is a view, backed by academic and practitioner research, to which Quintet subscribes. There are several distinct and popular sustainable investing philosophies, the most common being the “Leader” approach. Investors seek to identify companies that are performing well across ESG factors. They expect these companies will suffer fewer adverse events – such as accounting scandals – and believe that corporations who take a holistic approach to business will generate improved cash flows through factors such as increased customer loyalty, favourable regulatory treatment, and collaborative supply chain partners. The most commonly followed “Leader” equity benchmark is the MSCI ESG Leader benchmark. Since its inception more than 10 years ago, the approach has steadily outperformed traditional market capitalization-weighted indices.

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Some “Leader” strategies may favour larger companies due to their superior ESG reporting and disclosure. “Leader” strategies can also tilt towards the “quality” factor, because companies who manage their ESG risks and opportunities well also tend to excel at cash-flow management and are efficient in their use of capital. This can make “Leader” strategies ideal for periods of market turbulence. Since the beginning of the year, the MSCI ESG Leader ACWI index has outperformed its traditional peer by over 1.3%. Crucially, return attribution analysis reveals that the largest contributor is the MSCI-defined ESG factor, not a style, sector, or country tilt. Sustainable investing has passed the test!

                
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INVESTOR INTEREST

Interest in sustainable investing amongst private wealth clients has increased dramatically in recent years, as individuals seek to express their values and lifestyle choices through their investments. Investments are an incredibly powerful channel of personal expression. For example, analysis from Nordea indicates that moving one’s pension into sustainable funds was 27 times more effective in reducing one’s personal footprint than making significant lifestyle changes, such as reducing meat consumption and taking the train instead of the car.

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It is thus no surprise that sustainable investing strategies have seen a wave of investor inflows in the past decade. However, with Covid-19 triggering a recession and a large stock market decline, did investors stick with their convictions, or was sustainable investing only a “nice to have” during the bull market? The evidence is unequivocal. While investors raced to the exits and withdrew over USD 100 billion from active equity funds in 2020, sustainable funds enjoyed record inflows. This underlines the structural appeal of sustainable investing for individuals and the attractiveness of sustainable investing as an offering for asset and wealth managers. Sustainable investing has passed the test!

THE SUSTAINABLE INVESTING TOOLKIT

Increasingly, the basic principles of responsible investing are incorporated into all aspects of investment management – this is the case at Quintet. However, the dedicated sustainable investing toolkit, where ESG dimensions are the central contributor to investment performance, is growing. In addition to the “Leaders”, investors can supplement their portfolio with three other approaches, namely “Improvers”, “Thematic”, and “Dedicated assets”.

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IMPROVERS

Unlike “Leaders” that invest in the companies already performing strongly across ESG metrics, fund managers using the “Improver” approach seek to get ahead of the curve and identify those companies exhibiting positive ESG momentum. They argue that an improvement in ESG performance will lead to, or correlate with, an improvement in operating performance and a reduction in idiosyncratic risk. The rationale for “Improvers” is supported by a range of practitioner and academic studies, with Goldman Sachs concluding “we find the strongest alpha signals in laggard-to-leader moves on environment and social factors.”

Often, a fund manager will seek to catalyse ESG improvement directly through active ownership. This entails identifying companies with ESG deficiencies and working with management through dialogue and annual general meetings (AGMs) to rectify the situation. Here, interests are aligned. By addressing the problem, the company may improve its operations or de-risk itself in the eyes of investors, investors may enjoy an improved share or bond price, and people and the planet will benefit from the direct ESG improvement. Quintet believes in active ownership, and year-to-date has voted at over 200 shareholder meetings. For example, at the Microsoft Corporation AGM, Quintet supported a shareholder proposal requesting that the company disclose its global median gender pay gap across race and ethnicity, including base, bonus, and equity compensation. With our partner, Federated Hermes EOS, Quintet has also pursued active engagement with over 290 portfolio companies. For example, with a group of investors called Climate Action 100+, Quintet engaged with BP plc to request that the company set out a strategy consistent with the goals of the Paris Agreement – something BP plc has embraced with a pledge to be net zero on carbon emissions by 2050 or earlier.

                
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THEMATIC

“Thematic” strategies differ from “Leaders” and “Improvers” by explicitly focusing on unique exposures and structural trends. “Thematic” managers believe that these trends are currently underappreciated by the wider market and will grow faster and command higher valuation multiples as the world’s regulatory, investment, and consumption patterns shift. Examples include low carbon funds, gender equality funds, and water funds. “Thematic” strategies tend to have a bias to faster growing companies, rather than established corporations, and often tilt toward smaller firms who have the potential to grow into future behemoths. Interest in “Thematic” investing is growing very fast as investors are attracted to its long-term thinking and structural growth drivers. Over the past six months, “Thematic” funds have gathered assets at six times the rate of the broader sustainable investing fund universe. According to Goldman Sachs, they now invest approximately USD 300 billion of assets.

DEDICATED ASSETS

Unlike “Leader”, “Improver” and “Thematic” strategies, which start with a conventional investment universe and utilize specific investment philosophies to select stocks and bonds, “Dedicated Assets” are financial instruments that are explicitly designed with sustainability in mind. Examples include green bonds, where the proceeds of the bond are ringfenced for specific environmental projects, and multilateral development bank bonds, such as those issued by the International Bank of Reconstruction and Development (IBRD), which funds development across a range of countries. In terms of risk and return, “Dedicated assets” often closely mirror a conventional sub-asset class. For example, green bonds perform very similarly to investment grade credit, and multilateral development bank bonds track US Treasuries closely, while providing a small yield pick-up.

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THE PORTFOLIO VIEW

The strength of sustainable investing, within a portfolio context, is the ability to combine these four approaches to achieve investment returns throughout the economic cycle. Each approach harvests a diverse set of risk premiums and also provides different tilts to traditional factors. Combining the approaches creates a robust portfolio and will prepare a sustainable investor to pass future market tests!

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LOOKING FORWARD

Looking forward we expect private client interest in sustainable investing to continue to grow. Not only does sustainable investing improve the investment decision- making process, it also enables investors to align their wealth to their values and lifestyle choices in order to create a Richer Life.

Authors:
Bill Street - Group Chief Investment Officer
James Purcell - Group Head of Sustainable, ESG, and Impact Investing


This document has been prepared by Quintet Private Bank (Europe) S.A. The statements and views expressed in this document – based upon information from sources believed to be reliable – are those of Quintet Private Bank (Europe) S.A. as of May 04, 2020, and are subject to change. This document is of a general nature and does not constitute legal, accounting, tax or investment advice. All investors should keep in mind that past performance is no indication of future performance, and that the value of investments may go up or down. Changes in exchange rates may also cause the value of underlying investments to go up or down. Copyright © Quintet Private Bank (Europe) S.A. 2020. All rights reserved.