Tectonic shift to sustainable investing

It’s important to keep a long-term perspective amid market volatility – such as the extraordinary moves of recent weeks. One enduring trend we see is a move to sustainable investing: a structural shift in investor preferences leading to large and persistent flows into assets perceived as more resilient to sustainability-related risks such as climate change. Investors rebalancing portfolios after the risk asset selloff may consider leaning into sustainable assets.

Investors should keep a long-term perspective amid market volatility, including a focus on portfolio resilience through sustainable investing.

Historic US policy actions, including over $2 trillion in fiscal support and a raft of Federal Reserve measures, helped calm markets.

This week’s data are likely to show further signs of economic damage caused by the coronavirus outbreak and containment measures.

 

Source: BlackRock Investment Institute, as of March 25, 2020. Notes: Global sustainable ETFs as any exchange-traded funds that pursue a dedicated sustainable objective, whether using a broad ESG, thematic, impact, or exclusionary strategy. Traditional ETFs are any other ETFs that are not directly focused on sustainability.

We see a sustainable investing wave playing out in financial markets over the coming decades, remaking economies and industries as capital is reallocated to sustainable assets. This year’s fund flows may offer a miniature version of this shift. Sustainable exchange-traded funds (ETFs) have kept attracting assets this year, while traditional ETFs have seen heavy outflows in the market selloff. See the chart above. Net inflows into sustainable ETFs totaled $14 billion as of March 24, already more than half of 2019’s full-year figure, our data showed. To be sure: The total assets under management of sustainable ETFs are just 1% of that of total ETFs, and flows to sustainable funds are still very small compared with those to traditional funds. Yet the growing interest offers a glimpse of what may lie ahead: a significant structural shift toward sustainable investing, driven by broad societal preferences. As a result, we see portfolio rebalancing in the current environment as an opportunity to substitute some traditional assets with sustainable ones, with an eye on potential long-term benefits.

How should we expect sustainable investing strategies to perform over the long term? Skeptics have long argued the following: 1) Financial markets are efficient, so if sustainability matters it should already be reflected in market prices; 2) if investors care about sustainability, they should be willing to accept lower returns by paying a premium for “green assets”; 3) conversely, investors will earn a greater return as compensation for owning higher-risk “brown assets.” This logic leads to the conclusion that we can simply ignore sustainability: Tilting toward green assets will be costly and owning brown assets will offer relatively higher expected returns. We disagree.

Why? Financial markets are imperfect at pricing information about the far-off future, even when the structural shifts are well understood. Think of slow-moving demographic trends such as population ageing and its implications for asset prices. When we complete the transition to a low-carbon economy in which sustainability will be fully embedded in marketing pricing, assets backed by high sustainability will be more expensive – while other assets will have become cheaper or disappeared altogether, in our view. Sustainable assets should earn a return benefit during the long transition to this state, in addition to greater resilience against risks such as physical disruptions from climate change. This implies the conclusion that sustainable investing requires sacrificing returns is a myth, in our view. Sustainable investing will likely carry a return advantage over years and decades, as we detail in our recent paper Sustainability: the tectonic shift transforming investing.

This phenomenon could already be playing out to some extent this year. We studied the performance of sustainable assets versus major equity style factors since late January, when China first acknowledged the coronavirus outbreak. We used MSCI World ESG Leaders Index to illustrate the impact of investing in companies with strong ESG characteristics, and found that it has offered higher risk-adjusted returns than any major equity style factors including quality and min-vol. Moreover, other broad ESG indexes have slightly outperformed their traditional counterparts in many developed equity markets over this period.

 

Bottom line: Flows into sustainable assets are still in their early days, and we believe that the full consequences of a shift to sustainable investing are not yet in market prices. This implies a return advantage may be gained over the long transition.

 

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