Large structural changes in investment are taking place, says Pablo Berrutti, of Stewart Investors, Sustainable Funds Group. 

The market will ensure that alpha opportunities are taken advantage of.

So how long will the ESG trend last?

Customised portfolios will continue to benefit, Singh says. “The trend of incorporating client preferences is here to stay. Customised portfolios are here to stay.”

Chris Berkouwer, portfolio manager of Robeco Sustainable Global Stars Equity, agrees about the long-term horizon for sustainability portfolios.

“Historically, sustainability investing mainly focused on companies having proper governance practices,” Berkouwer says. “However, over time environmental concerns and, on the back of the COVID-19 crisis, social issues too, really cemented ESG as a core part of investment decision-making. We believe this tipping point in favour of ESG investing has sufficient stickiness to enjoy a long-term tailwind.

“Recently, much of the debate has centred around the question whether doing good equals losing money, as if there is a natural trade-off between the two,” he says. “Interestingly, the short answer is no. In fact, there is a growing body of academic evidence suggesting a positive relationship between sustainability investing and financial performance. It seems ESG has evolved from being a force only protecting against downside risk to one that also drives excess performance, or alpha. For example, global ESG funds have outperformed category peers on a three-, five- and 10-year basis, according to Morningstar.”

ESG is widely believed to be in its early stages. How ESG thinking affects individual businesses is yet to be seen.

Investors should be watching how businesses position themselves, says Pablo Berrutti, a senior investment specialist for Stewart Investors, Sustainable Funds Group.

“Over the long run, it is hard to imagine a scenario where sustainability issues become less important,” he says.

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“Whether driven by consumer demand, regulation, environmental constraints or technology, these shifts are structural in nature. However, in our view, rather than treating it as a theme, we believe the best way to find opportunities is by understanding how companies are positioned for these changes from the bottom up.”

The quality of management will be an important consideration, Berrutti says.

Integrating material ESG factors into fundamental analysis contributes to better investment decisions, says Victor Zhang, of American Century Investments. 

“While the waves may chop and change for short-term investors, we see the current pulling in one direction,” he says. “The managers and boards of companies who understand that and position their businesses accordingly will find it easier to deliver sustainable value over time, not just for shareholders but for all their stakeholders.”

American Century Investments chief investment officer Victor Zhang would like to see ESG issues as important inputs into fundamental analysis – the evaluation of intrinsic asset values to determine the factors behind their future prices – to reduce risk and accentuate upside potential. “Ultimately, we believe integrating material ESG factors into fundamental analysis contributes to better investment decisions,” he says. However, ESG will continue to evolve, with different issues assuming importance in the future.

“Global events in recent years have accelerated the shift in mindset toward sustainable investing – and more specifically in impact investing. Investors increasingly look to align their investments with their values and create a positive benefit for society,” Zhang says.

“These impact investments can help drive the transition to clean energy, increase access to clean water, provide quality education, improve health and wellbeing, and foster innovative solutions that alleviate poverty or inequality.

“We have seen particular demand from clients across regions for investment solutions that address climate change, focused on issues like clean energy and carbon transition. We have also seen interest for products that can create positive social impact, and in response, we have recently launched a healthcare impact strategy in Australia that addresses issues such as access to medicine and innovative treatments for diseases.”

Dugald Higgins, head of responsible investment and real assets at Zenith Investment Partners, makes a distinction between investing in exchange-traded funds, and active management of investment portfolios.

“For ETFs, utilising an index with a defined set of rules gives clarity on which securities are included or excluded,” he says. “In addition, ETFs’ daily disclosure of all portfolio holdings means investors can see exactly what’s held by the ETF at any point in time.

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“However, lack of regulatory disclosure and uniformity means ESG data isn’t always robust or comparable and can also suffer from lags, creating potential challenges for indexing,” Higgins says. “It also typically measures current actions, not transitional activity. For investors seeking to have a more material impact, selecting active managers whose ability to embrace a path to improvement may be more likely to result in greater real-world impact.”

Sin sectors on a roll

ESG v non-ESG investment becomes an interesting conundrum for investors. If opportunistic behaviour by investors pushes them towards ESG, then it’s a reasonable assumption that non-ESG businesses will become undervalued. The so-called sin sectors – those with higher carbon footprints – may at some point become good investments because they are being shunned.

“Our investment teams do find value in non-ESG-friendly sectors,” says Victor Zhang of American Century Investments. “And in fact, year to date, the performance of the energy sector has been more than double the broad market. By forgoing traditionally non-ESG-friendly sectors, investors may miss out on opportunities and leave returns on the table. Companies are not always static, business transform. Many of these oil and gas companies are heavy investors in alternative energy and spending R&D on future technologies.”

One has to be highly selective in favouring non-ESG businesses, says Chris Berkouwer, of Robeco. “Some non-ESG friendly sectors have done really well year to date, clearly reflecting the old economy is not dead yet.”

The co-existence of old and new economies is an indication of the slow pathways that businesses will take. “It also indicates the decarbonisation of global economies will probably take longer than many hope for,” Berkouwer says.

“Still, change is coming, so the less ESG-friendly companies that are not rethinking their business models are doomed to fail, eventually. The next ESG alpha opportunities are those improvement stories that are not yet well understood by others.

“As investors move away from simply excluding certain industries or change positioning purely based on ESG scores, having differentiated views based on more forward-looking, fundamental ESG insights will only increase.”

Bhanu Singh, of Dimensional, has a telling answer to this dilemma. “Ultimately the market will clear,” he says. “If I under-rate a stock, someone else will overrate it.”