James Purcell, co-author of Sustainable Investing in Practice, looks at how sustainable investing has been perceived over the past couple of decades and whether we should be optimistic about its future.
- When it comes to sustainable investing, our collective expectations have gone from famine to feast over the past decade.
- They are, however, stumbling back again as investment performance faltered and politicians put ESG on the culture wars menu.
- As we look to the future, we must recognise the nuances of sustainable investing and expect a rise in engagement.
It is often said that happiness is the difference between expectations and reality. If you lower your expectations ahead of your annual salary negotiation, then the crumbs of a sub-inflation increase taste delicious. When it comes to sustainable investing, our collective expectations have gone from famine to feast over the past decade, only to stumble back again as investment performance faltered and politicians put ESG on the culture wars menu. These dynamics cloud the outlook for the future of sustainable investments.
From famine to feast
In the early part of the 21st century, sustainable investing was not a mainstream cuisine. It was characterised by moralistic overtones and its key ingredient was the practice of exclusions – what you can’t invest in. Few people welcome being told what they can’t do, especially if it comes with a side dish of morality. Sustainable investing was in a time of famine.
The feast emerged in the mid-2010s as savvy brand positioning combined with a splash of superb investment performance. By the end of 2021, the global variant of the most widely followed sustainable public equity index celebrated its sixth consecutive year of outperformance over its conventional rival. Sustainable assets under management swelled and Goldman Sachs reported that, in 2021, sustainable funds received one of every four dollars of new investor capital. Meanwhile, at the political table, ESG-friendly US President Joe Biden acquainted himself with his new oval-shaped office. The sustainable investment feast was upon us.
However, the pot was to boil over. Senior sustainable investment employees at BlackRock and DWS critiqued their employers, questioning the ingredients that comprised their firms’ sustainable investing approaches. And a combination of rising interest rates and red-hot energy prices bit into the profits and valuations of sustainable companies. This caused a marked shift in tone. In 2022 Anne Simpson, the former head of sustainability at the Calpers pension fund, told a New York conference, “I think it’s time for RIP ESG”. And Barron’s declared that “sustainable investing failed its first big test”. Sustainable investing was no longer viewed as Michelin-quality.
Thinking about the future
When we think about the future of sustainable investing – and whether we can be optimistic or not – there are critical questions to answer.
The most important of all – and this might sound surprising – is, ‘what is sustainable investing?’ What are we being optimistic about? Pinning down sustainable investing is as challenging as defining Asian cuisine. The Institute of International Finance has identified over 100 partially synonymous terms and arguably the two most widely followed measures of assets under management – Morningstar and the Global Sustainable Investment Alliance – differ in their estimations by a whopping 1400% or a cool $30 trillion.
Sustainable investing is a rich smorgasbord of related activities, and as we look to the future, much like regional or national Asian cuisines, some are set to be more popular than others.
We can be most optimistic about the future of engagement – the practice of constructively discussing areas of improvement with corporate management. Logic dictates that should investors be able to identify deficiencies that have a material impact on corporate financial wellbeing then a company which listens to them and then fixes the problem will improve its operations, financial health and share price.
Thus far, a handful investment studies have suggested a positive relationship between engagement and investment returns. As we look to the future, the proof will be in the pudding as more rigorous studies should prove engagement’s worth.
Exclusion to come off the menu
In contrast, coming off the menu will be exclusion, which is fast approaching its sell-by-date. Despite the appetising appeal of simply refusing to purchase what you don’t like, unfortunately the decision to buy or sell a publicly traded security has little to no real-world impact. If, for example, you purchase shares in Apple (NASDAQ:APPL), no additional money goes to the tech behemoth. Your stock was issued by Apple decades ago and your order merely swaps shares in the secondary market, with you buying them from another investor. Apple is unaffected by your activity.
Academics from Stanford University and The Wharton School of the University of Pennsylvania who looked at this issue concluded that “current ESG divestiture strategies have had little impact and will likely have little impact in the future”. The reason? Because publicly traded markets are liquid and demand for securities is highly elastic. The researchers found that it would take 80% of all investible wealth to act in a sustainable manner to affect even a 1% change in a firm’s cost of capital.
As we look to the future, we must recognise the nuances of the sustainable investing palate. Having witnessed the entire sustainable investing ecosystem lurch from famine to feast and part way back again – the next course will be more complex. Engagement will be the star of the dish, with Exclusion pushed to the side.
James Purcell is the co-author of Sustainable Investing in Practice (Kogan Page, £34.99).
The opinions of guest authors are their own and do not necessarily represent those of SG Voice.