Investing sustainably through the economic cycle

by | Jul 27, 2022 | Commentary & Insights | 0 comments

Whilst it has been possible to invest in sustainably-focused funds for a long time, in recent years these types of strategies have become increasingly popular.

Not only is it topical in the light of current news headlines regarding sustainable energy and climate change, but the investment climate of the last 10 years has favoured companies which are typically included in these strategies. In markets, momentum can be a powerful force. Strong returns often attract more money to a sector which then further bolsters performance and so on.

The chart below illustrates the performance differential between sustainable investments (ESG 60/40 portfolio) versus more traditional investments (Core 60/40 portfolio). This has been relatively significant with the former outperforming by almost 23% in the four years to the end of 2021.

While sustainable investment strategies have clearly performed well, it is important to understand the drivers of this performance and not forget that there are often reasons for this.

The main driver of performance is usually risk, and in this case, the link between higher risk generating higher returns. Naturally, sustainable investment strategies have a smaller pool of companies to invest in as they must exclude those that do not meet their specific criteria. Therefore, by their very nature, whilst still diverse, they are more concentrated and usually tilted towards specific sectors or areas of the market. It is this concentration and focus that makes them higher-risk.

The higher concentration in sustainable strategies means that, when the economic environment changes, a run of outperformance can quickly turn into a period of underperformance. This is normal and is nothing to be concerned about, as long as you are clear on your investment objectives, have a suitable time horizon and an understanding of why this happens.

Since the beginning of 2022, the economic environment has changed significantly, notably favouring commodities and energy stocks which tend to be excluded from sustainable strategies. Below is a chart comparing the same portfolios as above over the first six months of 2022. Clearly, the sustainable portfolio has struggled as the market environment has shifted to favour other areas.

Off the back of very strong performance throughout 2020 and 2021, though still diversified, our TM ‘Investing for Good’ (IFG) strategies have suffered more volatility than our traditional core strategies. With this in mind, it’s important for investors in IFG strategies to remember the following:

  • First and foremost, by using these strategies you are allocating your capital not just for the highest return, but in line with your investment preferences that match your overall sustainable and ethical views.
  • When a strategy has enjoyed a period of outperformance, it is natural for it to be followed by a period of underperformance. Higher long-term reward requires greater short-term risk (volatility).
  • Sustainable strategies are typically concentrated in growth-focused companies. As more of their value is derived from future earnings, they currently face a significant headwind in the form of higher interest rates which results in greater discounts to the value of their future earnings.
  • Sustainable strategies typically screen out sectors such as energy and mining which have benefited from higher commodity prices since the turn of the year.
  • If you have been invested into a sustainable strategy for a long period of time, you will have enjoyed significant gains in previous years which should more than offset this period of volatility.

If you have only more recently invested into a sustainable strategy, then it is important not to make short-term decisions based on performance, but rather revisit why you wanted to invest in this way in the first place and also your wider objectives and requirements. Ultimately, as we move through the various stages of the market and economic cycle, different sectors outperform at different times. No area outperforms forever and eventually the cycle comes full circle.

It was not that long ago that, for the fifth or sixth time in his decades-long career, people were saying that Warren Buffett’s traditional value-based investment strategy was a thing of the past. Once again, they were proved wrong very quickly when the world changed at the beginning of this year and his period of underperformance turned to outperformance once more.

Investing, whether sustainably or otherwise, is not about how you start, but how you finish.

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