Sustainable Investing Shines During Market Gloom

If sustainable investing did not garner serious consideration before this year’s market meltdown, it likely will now. According to Morningstar, 70% of sustainable equity funds – which incorporate environmental, social and governance factors (ESG) in their investment mandates – finished in the top half of their respective Morningstar categories during the first quarter of 2020, when global markets fell sharply on worries about the COVID-19 coronavirus. The funds still experienced losses, but not as much as their conventional peers. What’s more, 44% of sustainable equity funds ranked in the top quartile during that period, while just 11% finished in the bottom quartile.¹

Sustainable: A New Definition of Quality

Sustainable investing has long satisfied the desire to do good while investing. But increasingly, the approach is proving it can deliver attractive investment returns, too – a point that may become only more evident in years to come as the world inevitably transitions to a sustainable economy.

Some three decades ago, the United Nations defined sustainable development as that which meets the needs of the present without compromising the ability of future generations to meet their own needs. In our view, four environmental and social megatrends challenge that goal: climate change, natural resource constraints, population growth and aging populations. We believe each megatrend is putting the global economy under enormous pressure, with far-reaching investment implications.

To that end, we think companies on the right side of these challenges – firms aligned with the development of a more sustainable global economy – could be best positioned to benefit from this disruption. And COVID-19 is helping underscore that point. Looking specifically at the performance of sustainable index funds versus conventional equity market benchmarks, Morningstar found that one reason for these funds’ outperformance was their tendency to be underweight energy stocks, which on average saw the sharpest declines of any sector during the period. An overweight to the technology sector also made a small contribution to outperformance.

The biggest differentiator, though, was the funds’ investment in companies with ESG credentials: firms that are well informed about environmental challenges, prioritize stakeholders and govern themselves in ethical ways, all of which appears to have contributed to the companies’ resilience. “They are the quality companies of the 21^st Century, and quality companies tend to hold up better than their lower-quality counterparts in difficult markets,” said Jon Hale, head of sustainability research at Morningstar, in a recent article.²

One way we think investors can determine quality using an ESG lens is to ask if a business is likely to contribute to the development of a sustainable global economy. Clean energy, water management, sustainable property, knowledge and technology, and quality of life – firms focused on these and similar areas are more likely to have durable and compounding revenue growth over the coming decade, in our opinion. Conversely, companies that negatively impact the environment or society should be avoided. In our view, firms inflicting harm are much more likely to experience discontinuity risk by virtue of increasing regulatory scrutiny and societal pressures.

Performance Diverges

That risk came into sharp focus earlier this year. Demand for oil, for example, plummeted as COVID-19 spread and the global economy stalled. At the same time, an oil price war between Russia and Saudi Arabia threatened to push up supply (and caused crude prices to sink). But a joint report by the International Energy Agency and the Centre for Climate Finance & Investment at Imperial College Business School found that a portfolio of renewable energy stocks gained 2.2% from January through April this year, compared a total return of -40.5% for a portfolio of fossil fuel companies.³ In other words, renewables offered greater resilience during the market upheaval. Going forward, we believe oil’s price volatility could be a headwind for future investment in fossil fuels while more capital is directed at renewable projects.

Digitalization has also accelerated, as we recently discussed in our article Sustainability and digitalisation: speeding the transition to a low carbon world. Before the pandemic, advanced computing power and lower costs were allowing for industrial, consumer and technological economies to merge. The pandemic has only fast-tracked this trend, with what we think could be lasting consequences – and which, in our opinion, is likely to favor companies prepared to compete in a digital and sustainably driven world.