After a stellar 2020, pockets of the sustainable investing market have struggled in 2021 as investors rotated their portfolio exposures. We’ve analysed more than 3,000 sustainable investing funds and conclude that mainstream sustainable investing strategies are robust and well positioned to benefit from favourable multi-year structural trends.
Sustainable investing enjoyed a stellar 2020. Flows into sustainable funds hit a record high of USD270 billion, according to Goldman Sachs. Morningstar research revealed that sustainable equity managers outperformed their conventional peers, with 43% placing in the top performance quartile and just 6% placing in the bottom.
As social attitudes continue to evolve and technological development accelerates across critical sectors such as food, energy and transportation, the multi-year sustainable investing story is robust. When we consider the economy of 2050, the environmental, social and governance agenda will almost certainly have advanced significantly. Examples include the predominance of plant-based and cultured meat alternatives, renewable energy sources and electric vehicles; the frequency of flexible and remote working; and greater governance transparency brought on by alternative real- time data sources. Our future economy and daily lives are on an irreversible path of change.
However, financial markets rarely move in a straight line and so far 2021 has been a speed bump for some sustainable strategies. In corners of the sustainable investing market, exuberance developed in 2020, and has since moderated. For example, investor appetite for clean energy has subsided from unsustainable levels (figure 1).
To a far lesser extent, the popular MSCI SRI sustainable exchange-traded-funds (ETFs) have also struggled due to a combination of idiosyncratic risk and factor rotation. In the US, MSCI SRI had outperformed its conventional peers for five consecutive calendar years (figure 2). However, in February, it suffered an underperformance of 2.2%. This is the largest monthly underperformance since the index went live in 2011, and a 2.7 standard deviation event – something that would be expected to only happen once every two decades. The primary culprit is, unusually, a single stock – Tesla, which has an overweight position in the MSCI SRI index family. Attribution analysis reveals Tesla accounts for around 50% of the underperformance and approximately one-third of the active risk compared to the conventional index.
Despite this notable underperformance, it should be remembered that sustainable investing is not a homogenous strategy. Two rational investors can disagree on the sustainability of a given company, much like they can disagree on its financial attractiveness. As a result, many other sustainable strategies have continued to perform strongly. For example, MSCI’s ESG Leader indices, which are more diversified than their SRI counterparts, fared better. In February, the US ESG Leader index actually beat the conventional benchmark by 0.5%, while sustainable active funds have delivered a range of outcomes.
At Quintet we are firmly of the opinion that incorporating sustainable factors into financial analysis adds to our investment approach, particularly when done in a principled and considered manner – rather than as a set of rules or checkboxes. That said, we are not dogmatic, and remain open to counterpoints and vigilant to prevailing market conditions. That’s why we consistently monitor the sustainable investing marketplace and funds to detect signs of overexuberance and investment risk.
Using research from Goldman Sachs, we consider around 3,000 sustainable equity funds, representing about USD1.5 trillion of assets. By looking inside the funds we can identify the stocks that are – in aggregate – considered sustainable by investors, and observe the characteristics and potential investment risks.
A valuable analysis is to monitor the valuation premium – or discount – these stocks have compared to the wider market. Figure 3 shows the 50 stocks with the biggest overweight relative to the benchmark by percentage points and by relative weight. For example, if company A makes up 3% of sustainable equity funds’ aggregate holdings and 2% of the benchmark, its overweight is one percentage point and its relative weight is 1.5x. The percentage point method tends to identify popular larger companies, while the relative weight method identifies popular smaller companies.
The analysis reveals that sustainable companies do trade at a premium to the wider market. Given the strong structural drivers, this revelation is not too surprising or concerning. The valuation premium of the 50 stocks with large percentage overweights has remained relatively constant over the past 12 months. However, the 50 stocks with large relative overweights climbed considerably in 2020 and have partially retraced in 2021. From this data we conclude there is no widespread bubble in sustainable stocks and funds. However, among smaller companies and niche themes – such as clean energy – there may be excess exuberance.
We can use the same data to identify stocks where sustainable investors have a disproportionate ownership (figure 4). These companies may be squeezed higher if inflows continue into sustainable funds, but they could experience selling pressure if sustainable funds were to suffer outflows and forced to liquidate their holdings. This analysis is an example of the value a sustainable investing lens can add to a fundamental equity process.
The recent pockets of sustainable underperformance are a timely reminder of why it’s important to construct diversified portfolios. Current market conditions are precisely why we use a sustainable toolkit that incorporates sustainability to construct investment strategies with different factor exposures (figure 5). You can read more about our approach here.
For example, investing through just a thematic lens, which typically has a growth bias and a smaller-size focus, would leave an investor exposed in periods of factor rotation. By combining the thematic approach with leaders, improvers and dedicated assets, multiple sources of return can be potentially harvested and factor biases partially mitigated.
The market’s recent activity is also a reminder to consider both active and passive approaches when constructing a sustainable portfolio. As many aspects of a company’s sustainability, and the consequence for investment returns, are open to interpretation and debate, it’s important to construct a portfolio that incorporates multiple viewpoints and avoids concentration risks.
After a stellar 2020, pockets of the sustainable investing market have retreated in 2021. The underperformance has primarily been restricted to individual themes and smaller companies, while larger sustainable companies and some popular indices have fared better. We believe sustainable investing is underpinned by powerful structural trends. It is important to create diversified portfolios, using a sustainable investing toolkit and to blend active and passive strategies. Looking forward, we are confident in the structural case for sustainable investing.
Around the world, Covid-19 cases have reached 118 million and the number of fatalities related to the virus now exceeds 2.6 million. However, global new infections per million people are stagnating at a similar level as in late October. In Europe, the number of new infections is stagnating too, with rising numbers in France, the Netherlands, Germany and Italy offset by continuous declines in Spain and the UK, with the latter now facing fewer than 10 new infections per 100,000 inhabitants (figure 6). The lack of further declines in new infections despite ongoing lockdowns and vaccinations is mainly due to further spreading mutations. New cases in the US continue to decline and are down by roughly 80% from January’s peak – but there has also been less testing.
Nevertheless, with vaccinations now reaching more than 15 million people per week, Washington University’s Institute for Health Metrics and Evaluation predicts a continued decline of infections in the US despite new mutations. The British variant accounts for 15–25% of new US cases and is dominating in areas such as Florida. Surprisingly, the state is coping relatively well with this fact due to warm weather, while other areas, such as New York, are struggling.
A third wave may be imminent in some countries because of the spreading mutations. Therefore, lockdowns are being partly prolonged in some places, such as Italy. Countries like Germany, where the British mutation is now dominating, and the UK plan to loosen restrictions gradually. France isn’t intensifying its measures despite high infection levels. Meanwhile, new infection trends vary from state to state in the US, so the speed of easing restrictions varies considerably. However, the accelerating pace of vaccinations should enable the removal of restrictions, allowing for meaningful reopenings in the next few weeks.
Vaccination plays a decisive role in the disease pathways. While both Europe and the US are making progress, the eurozone is still lagging the US and UK. In the eurozone, around 8% of the population have had at least one shot, but only around 3% are fully vaccinated (figure 7). But additional vaccine deliveries, which could cover at least a third of the German population in Q2, are raising hopes.
Further positive developments are the approval of Johnson & Johnson’s vaccine in the US and its likely approval in the EU, as well as the EU’s approval of the AstraZeneca/Oxford University vaccine for younger people – although several EU countries have temporarily suspended the use of this vaccine, given some potential side-effects. BioNTech/Pfizer raised the production target for 2022 from 2 to 3 billion doses. However, in the US, as well as in the UK, Germany, France and Italy, the proportion of people who refuse vaccination is around one-fifth. Widespread willingness to get vaccinated is important to achieve herd immunity and reduce the risk of further infection waves, allowing for broad reopenings and a real return to our normal lives.
James Purcell Group Head of ESG, Sustainable & Impact Investing
Daniele Antonucci Chief Economist & Macro Strategist
Bill Street Group Chief Investment Officer