As core equity and fixed income asset classes have struggled with tumbling values and investor drawdowns throughout a turbulent 2022, ESG funds and related themes and asset classes have proven more resilient, showing investors that there may be another way to invest into future gains.
It has been over two years since RL360, the international assurer, introduced a series of measures designed to provide greater choices for those looking to invest responsibly, while also making it easier for investors to assess quite how ‘ESG' funds available on the provider's platform really are.
Since then, on the regulatory front, there have been significant changes intended to encourage even more capital into ESG related projects and investments. In the EU, this has been marked by the introduction of SFDR into job streams at asset managers - the Sustainable Finance Disclosure Regulation that forces fund providers to explain their approaches and provide transparency around so-called Article 8 and 9 labelled funds. The Association of the Luxembourg Fund Industry has suggested that as of 2022, Europe holds 83% of global sustainable funds' net assets, reaching some EUR2 trillion by the end of 2021.
About a year ago, the UK played host to the Covid-delayed COP26 conference in Glasgow. This international gathering of governments resulted in a renewed policy push globally towards decarbonisation. A year on, the UK has a new prime minister, facing an energy crisis in which there have been increasing calls to decouple renewables-based energy prices from fossil-based energy prices. The latter are being manipulated by supply side issues linked to the ongoing conflict in Ukraine - when Russia closes the Nord Stream pipeline for "repairs", it drives up the price of gas, which sets the overall price of energy in the UK, putting the ‘S' in ESG in focus as households struggle to afford energy bills.
In other regions, such as the Middle East, ESG might be seen as playing catch-up in investors' minds, but here too there are measures being put in place by providers such as RL360 to help educate on at the very least the opportunities that exist for those willing to look.
International Investment, a publication for international financial intermediaries, surveyed an audience attending its Forum in Dubai in November 2021, at which some 26% said they had clients who wanted a full ESG strategy.
Chris Corkish, RL360 investment marketing manager, said at the time: "Whilst product providers are responsive to market demand, in the case of ESG we have decided to proactively provide credible options as part of an overall ESG strategy that seeks to develop understanding and sophistication in this area for clients and advisers alike."
Asia is another area of developments, where Corkish highlights Singapore. In July 2022, the jurisdiction's financial regulator, the Monetary Authority of Singapore (MAS) published a circular - CFC 02/2022 Disclosure and Reporting Guidelines for Retail ESG Funds - which set out MAS' expectations on "how existing requirements under the Code on Collective Investment Schemes and the Securities and Futures (Offers of Investments) (Collective Investment Schemes) Regulations apply to retail ESG funds, and the disclosure and reporting guidelines applicable to these funds."
Data story
Beyond the context of guided architecture like that offered by RL360 used to help point investors towards ESG funds and themes, there is also a question of what evidence there is of ESG derived investments behaving better than ‘non ESG' investments.
2022 has been a year of stresses in markets, which has seen investors pull back sharply both from risk assets, but also certain core so-called ‘risk free' assets. For example, the yield on UK 10 year government debt shot up 325% in the year to 1 September 2022, according to data published by the Financial Times. The FTSE 350 index, which offers a broader proxy measure of the state of the UK economy, in contrast to the FTSE 100, which is dominated by globally active businesses, was still slightly below its pre pandemic levels, and down some 4% over the past year to 1 September, having experienced several troughs over the period.
In its 2020-21 annual report the UK's Investment Association (IA) noted cash holdings had been built up in response to the global Covid pandemic. Not yet published as of writing, the 2021-22 report is likely to show a similar trend, especially given the volumes of net outflows from core equity and fixed income asset classes in the IA's most recent June 2022 data covering UK and recognized overseas funds during the previous eight quarters.
So, if investors are shy of both government debt and company equity in one of the world's biggest economies, and have been building up cash holdings, what does this suggest regarding the question of resilience around ESG investments?
It is worth noting the IA's take on ESG here. In a previous ESG survey published in the second half of 2021, it noted "Investors are trying to mitigate risks by investing with companies that align with their values, as well as generating financial value."
The reference to ‘risk mitigation' gives a clue to one factor explaining the resilience of ESG funds. On the assumption that such funds are invested in underlying holdings that create a different risk profile, then they could well be better able to withstand market volatility and uncertainty.
In April 2021, Mara Dobrescu, a director on the Morningstar Manager Research team, noted in a video interview that "We found that funds that courted less ESG risk beat their specific index more often than funds with lower ESG ratings. For example, around 46% of the funds that had a high globe rating outpaced their benchmark while only 30% of the funds that had only 1 or 2 globes did the same. So, on average, investors got a better payoff in funds that courted less ESG risk."
It is worth noting that the Morningstar sustainability ratings cover over 40,000 funds and more than 12,000 companies, according to the Sustainalytics website in early September 2022.
Exposure to themed strategies
Another factor to consider on the question of resilience relates to the level of exposure ESG funds offer to thematically derived investment strategies.
The Morningstar Global Thematic Funds Landscape 2022 report notes, for example, that "Europe is the largest market for thematic funds, accounting for 55% of global thematic fund assets." It adds: "Actively managed funds account for the majority of assets invested in thematic funds."
And in the Thematic Fund Taxonomy outlined in the report, it is easy to spot themes that not only play well to ESG values of investors, but that also tap into faster growing industries that are based on policy direction globally, for example, around emissions. The Taxonomy notes areas such as battery technology, electric vehicles, alternative energy and renewable energy.
Themes supported by policy direction may be seen as more resilient by investors, particularly if there is explicit legislation lending support to either direct public investments into these areas or outlined fiscal benefits.
Consider, for example, the US Inflation Reduction Act, which passed into law in August 2022 and which contains provisions extending a tax credit on solar investment for 10 years. Morningstar notes that the energy transition theme includes "firms that design, supply, build, and/or operate wind, solar, and hydrogen-based energy solutions". Thus, a 10 year tax credit on solar investments arguably changes elements such as the projected compound annual growth rate (CAGR) or internal rate of return (IRR) associated with the investment thesis, and being over such a long period of time makes these more resilient.
RL360's architecture gives investors access to the themes of climate change, resources and energy, sustainable, human development and water and waste, as well as approaching these on a multi-thematic basis and approaches beyond equites in multi-asset and fixed income asset classes.
The trends are, of course, not limited to active funds. In one of his Monday Morning Memo notes, published at the end of August 2022, Detlef Glow, Head of EMEA Research at Refinitiv Lipper, noted about European inflows to ETFs that "a more detailed view of the flow numbers by asset type shows that ESG-related funds were enjoying high inflows."
"Given the high inflows over the years 2020 and 2021 and repurposing of conventional funds to ESG-related products aligned to article 8 and 9 of the SFDR brought ESG-related investment strategies from niche to mainstream and the trend toward ESG-related products is expected to continue. This is because investors are increasingly aligning their portfolios with ESG-related targets. Therefore, it is not surprising that we witnessed a lot of activity regarding launches of ESG-related funds and mergers of existing products into these new products."
Passive funds shift
The shift in passive funds towards ‘sustainability' is noted also in the 2022 European Sustainable Investment Funds Study by Morningstar and Zeb, which was commissioned by the Association of the Luxembourg Fund Industry, suggesting a trend that will continue even amid uncertainty in markets.
Commenting on the prevalence of funds investing against ESG objectives, Hortense Bioy, global director of Sustainability Research at Morningstar, noted in August this year in a review of the SFDR status of funds that: "Over the last three months, 713 funds altered their SFDR status, including 696 that upgraded and 16 that downgraded. The vast majority (652) that upgraded their status moved from Article 6 to Article 8, while 17 funds upgraded from Article 6 to Article 9. Fund companies are clearly feeling the commercial pressure to have as many funds as possible meeting at least Article 8 requirements."
However, the ongoing role of regulators is also impacting the delivery of such funds.
"As regulators continue to provide further guidance on the implementation of SFDR, we can expect more funds to be reclassified to Article 8 in the future," Bioy added.
From a non-traditional risk perspective, "in aggregate, Article 8 and 9 funds perform better on ESG metrics than the rest of the universe," the Morningstar research suggests.
So, even in periods where investors were switched into ‘risk off' mode - such as during the first half of 2022 - it would seem funds viewed as having different risk profiles precisely because of their commitment to non-traditional risk factors have outperformed the more traditional investments.
This is perhaps not surprising, considering the different asset exposure and investment themes, as well as the policy direction and even fiscal stimulus given to ESG focused investments.
As such, it does seem that ESG investments have proven and will continue to prove resilient in periods of market stress.