Sustainable investments have become an integral part of the daily activities of institutional investors. So how does one invest sustainably and what performance can one expect?
Principally, the various approaches in this field are broken down into two main categories:
The voice approach attempts to actively steer companies in a sustainable direction. In its simplest form, this is done through the exercise of voting rights at general meetings. “Active ownership” is a more engaged approach where direct contact is sought with company management with the aim of incorporating sustainability criteria in the business strategy.
Under the exit approach, securities are specifically excluded from (negative criteria) or integrated in (positive criteria) the investment strategy. Common exclusion criteria include alcohol, tobacco, gambling, pornography and controversial weapons. The application of positive criteria involves active decisions as to which securities to invest in.
Furthermore, a distinction is made between the best-in-class approach, ESG integration and impact investing:
Under the best-in-class approach, leading companies within a sector are identified according to ESG scores and given an overweight position.
ESG integration specifically incorporates sustainability criteria into valuation models.
Impact investing focuses on a specific sustainability aspect, such as green bonds, infrastructure investments or microfinance.
Defining sustainability criteria
Sustainable investment policies always start with the definition of sustainability criteria based on the investor’s business purpose and/or political standards. However, in certain investment categories, the definition of appropriate forms of sustainability can be fuzzy and compliance with ESG criteria can be a challenge, especially in the case of passive investments. ESG-based exclusion of specific securities adds systematic risk to investments, creating a tracking error against the traditional benchmark.
In terms of active implementation, there is the question of identifying the best approach to achieving the investor's sustainability goals. Investment controlling monitors compliance with sustainability criteria and shows the impact of sustainable investments on risk and return.
Differences in study results
A large number of academic and empirical studies have been conducted on the subject of returns on sustainable investments. The majority of the studies conclude that sustainable investments generate at least the same returns as traditional portfolios. However, some studies also come to the opposite conclusion. In 2017, for instance, Blitz and Fabozzi found that ‘sin stocks’ may generate above-average returns. In 2018, the asset manager Amundi demonstrated that, before the year 2014, sustainable investments resulted in lower returns compared to the market portfolio. Nevertheless, these heterogeneous study results show that, although sustainable investments may not necessarily deliver higher returns, they have a positive impact and reduce risks.
Now the challenge is to create the right incentives to ensure that the market internalises the costs of the external impact of reckless resource depletion. Economics teaches that the resulting inefficiencies can thus be minimised and will ultimately lead to a welfare gain. The next few years will show whether this theory also translates into practice where sustainability is concerned.