The relative resilience of ESG strategies through the recent market rout could mark a watershed moment for sustainable investment.
Fleeting trends are usually the first to be abandoned in the heart of the storm. This simply hasn’t happened with ESG strategies. In fact, quite the opposite, with many funds charting inflows through Q1 2020.
Cynics may attribute ESG outperformance to sector positioning. Undoubtedly, ESG funds’ limited exposure to oil and energy has been a major factor behind these strategies’ recent returns. Yet even on a sector neutral basis, ESG funds’ typical bias towards quality, well-run businesses, underpinned by good governance and strong balance sheets, has helped investors avert the worst of the turmoil. When the rubber hit the road, strategies premised on mitigating ‘non-financial risks’ have outperformed.
Looking ahead, the ubiquity and scale of the coronavirus crisis may radically reconfigure investor perspectives on what ‘sustainable’ actually means, and erase for good the perception that it is just about ticking boxes. It is about making decisions in the best interests of society and your workforce, allocating capital responsibly and mitigating the climate impact of your business.
COVID-19 has given us a palpable sense of what a global challenge – like climate change – looks and feels like, and this experience will likely accelerate corporate and regulatory action. Companies’ social purpose and their treatment of employees has never been more closely – or publicly – scrutinised, and firms’ actions today will shape their future.
On the other side of this crisis, increased focus on the role of human capital management, climate action and responsible balance sheet management will accelerate ESG investing.
Of course, flows into ESG strategies have already risen exponentially over recent years. In practical terms, the rising flow of capital into sustainable funds has already driven significant shifts in the nuts and bolts of the industry – in fund-raising, seed capital and the way in which investment mandates are awarded.
EY research on the implementation of ESG strategies among 17 UK-based asset management firms – with a collective AUM of £9.5tn – definitively evidences this shift.
Firms told us that both institutional investors and high net worth individuals are now willing to commit their own capital in order to seed and launch new sustainable funds; moving away from the traditional ‘beauty parade’ process premised on long-term track records.
The move to seed entirely new, untested products marks a key shift in the industry. While seeding new funds has become relatively commonplace in the private markets’ arena, where many institutions have built large in-house teams of specialists to work with General Partners and fund managers to deploy private capital either direct or via partnerships, this approach remains much less common in more traditional public equity or credit-based strategies.
Given that many sustainable strategies lack the traditional minimum three- to five-year track record of returns, the meteoric rise of sustainable strategies threatens to throw a major curveball into the manager selection process. On what metrics will investors now base their decisions?
This is the key question looming over the industry, which is set to continue growing at an astonishing rate. Of the roughly $100tn assets under management across firms globally in December 2019, around a third was classified as being invested in sustainable mandates or funds. Given the major shifts driven by the recent market turmoil, the proportion of assets in sustainable funds will have risen exponentially.
For now, the sustainability industry continues to operate and evolve without a constituent taxonomy or standards. Every manager we surveyed is reporting differently, making it extremely difficult for institutional investors, let alone end beneficiaries, to assess different managers’ credentials.
Until regulation and industry-wide definitions have caught up with product development in the sustainability, ESG and impact space – clarifying exactly what constitutes “integration”, “sustainable” and “green” in an investment context – investors will continue to face a raft of potentially subjective decisions as they work to build (and rebuild) more sustainable portfolios.
Encouragingly, firms across the asset management industry are working hard towards a new set of definitions. The recent launch of the EU’s categorisation system for financial products, hailed as the first concerted attempt to formally classify sustainable investments, has provided a key support to these efforts, while the Investment Association’s work towards clarifying the industry’s taxonomy and standards has been another important step.
In the near term, the asset management industry has a huge opportunity to build and document tangible evidence of ESG strategies delivering when the heat turned up. After the crisis, the opportunity will be to rebalance focus more on the ‘S’ and ‘G’ by demonstrating purpose and value to society, as well as working alongside regulators, governments and investors to build a new set of benchmarks, purpose-built for a more sustainable future.