Factoring sustainability into portfolio decisions

Asset owners remain understandably challenged to incorporate sustainability factors into global equity allocations. Global macro trends make clear that sustainability considerations will be increasingly essential for consideration, but often less clear is how to factor this into portfolio decisions in a sophisticated manner.

Dwindling natural resources and the world’s related ‘carrying capacity’ is translated by the Global Footprint Network into the concept of “global overshoot”. This year, apparently, the world will consume 1.5 times the amount we should do in order to remain relatively sustainable as a planetary whole. Reaching this point earlier in the year on an ongoing basis pretty much ensures that natural resources will become scarcer over time, with demand/supply dynamics likely to impact corporate profit levels and related portfolio valuations. That is unless companies increase value-chain efficiency or otherwise can pass on increased costs to ever-budget conscious global consumers.

The likes of Jeremy Grantham and Jason Schenker of Prestige Economics talk at length of this coming inevitability, as well as related effects from overpopulation, extreme weather linked to climate change, ongoing challenges to biodiversity and more, all of which may seem daunting, not only from a fund management perspective.

Outperformance

The good news is that outperformance has already been seen by forward-looking mostly large-cap companies, and so the opportunity to weight portfolios towards sustainable innovation and best practice on sustainability has emerged as a vital strategy for asset owners to consider.

Examples of this outperformance abound. In classes I teach at the University of Maryland’s Smith School of Business and Columbia University’s Earth Institute, we have constructed what have gone on to become outperforming portfolios using just this sort of methodology.

One challenge has been that while sustainability-driven companies outperform, predominating negative approaches to the field do not and have not performed well. So, asset owners remain unconvinced. It is critical to parse out positive ESG approaches from negative ones, and the difference in performance has been dramatic.

Sustainability: many things to many people

The definition of sustainable investing can vary, but it calls for future-oriented investment with sustainability risks and opportunities firmly in mind, measured in a sophisticated manner, including keeping one eye firmly on the viability of the business as a whole and another on the quality of management, including factors such as trust and culture. Culture has emerged as a key indicator of success from a sustainability standpoint.

Companies that are both innovative and can manage their sustainability risks successfully belong in such portfolios. Apple, for example, has managed well its lengthy environmental and social challenges.

Prior to this, in Sustainable Investing: the Art of Long-Term Performance, my co-authors and I demonstrated outperformance from positively focused sustainability mutual funds for the one, three and five years leading up to the end of 2007, while negative approaches at best met market returns. And so I understand the widely held belief that asset owners cannot outperform through socially responsible investing (SRI), however this is a direct function of the sophistication of existing and available strategies. Other examples abound. In April 2012, a sustainable innovation portfolio focused largely on US companies had performed over 50 per cent better over the previous five years versus the S&P 500.

The S&P 500 over the last five years – less coal, oil and financial services and double weight tech – has done much better than the plain vanilla S&P 500. The top 100 of the Newsweek Green Rankings companies over the first two years outperformed the S&P 500 by 4.8 per cent. These may come across as a series of correlations, but larger trends may also be afoot.

As pointed out in Evolutions in Sustainable Investing, over 90 per cent of SRI portfolios in the US remain largely focused on negative approaches such as taking a benchmark and subtracting alcohol, tobacco and firearms. Environmental considerations in such portfolios tend to be retrospective views of past violations, rather than seeking companies finding revenue streams from solutions to sustainability challenges going forward, and hence are not indicative of finding opportunity.

From a fiduciary duty standpoint, all asset owners need to attempt to maximise returns, and so it is exciting that a focus on sustainability trends can help with this, so long as a positive, well considered iteration of sustainable investing is applied. Negative approaches have understandably not convinced fiduciaries. Positive opportunities focused strategies may one day be the definition of fiduciary duty itself, and these strategies retain the potential to create a dynamic, which if applied by enough of the market, could drive the sort of change which would benefit all categories of stakeholder.