The popularity of responsible investing has soared in the past year. Net flows into environmental, social and governance (ESG) funds surged by 300% year on year to reach in excess of £7bn in 2020.
This rise mirrors changing attitudes towards environmental and social issues among consumers that could provide investors with opportunities to generate high returns. With a rising number of companies and funds becoming conscious of the popularity of ESG-related issues, the range of opportunities available to investors within the responsible investing segment is increasing. Of course, rising popularity does not necessarily equate to investment success.
The subjective nature of defining what counts as a responsible business, as well as diversification challenges, are examples of potential threats that could derail investor returns within the ESG sector.
One of the most appealing aspects of responsible investing is its potential to deliver high returns. Interest in ESG was already a well-established trend among consumers prior to the Covid-19 pandemic, and it appears to have gained yet more traction during the past year.
For example, management consultancy firm Accenture reported in 2020 that 60% of global consumers are making more environmentally friendly and ethical purchases than they were before the pandemic, and most of them expect to continue doing so after Covid-19 passes.
This suggests companies that successfully adapt to changing consumer trends towards ESG-related factors could gain market share, allowing them to deliver higher profitability in the long run.
Rising consumer expectations surrounding ESG matters mean an increasing proportion of companies are likely to aim to cater to their needs. A wider investment universe allows fund managers to become more selective in terms of their holdings. This could lead to stronger returns in future, as well as reduced risk from providing greater opportunities to diversify.
ESG investing enables investors to hold some of the most innovative and fast-growing businesses from across the global economy. For example, infrastructure funds that invest in wind, solar and other sustainable energy assets may experience stronger growth rates than fossil fuel businesses.
They may benefit from, rather than be held back by, changing regulations that seek to reduce carbon emissions.
In addition, various studies have shown that strong corporate governance has been linked to sound company performance. Areas such as risk management and having an effective board can lead to better decision making among directors, enhancing profitability and investment performance over the long run.
Responsible investing may also be worthwhile because it is likely to be driven by an emotional response as well as profit. An investor may see an opportunity to generate high returns from ESG funds or companies, but additionally be guided by their moral compass.
This can be beneficial to their long-term returns, since it may prompt them to adopt a more patient approach, giving holdings time to deliver on their potential.
Beware the hazards
Of course, emotions can have a negative impact on investment performance in some cases. For instance, they may mean an investor loses sight of their primary goal of making high returns. They may fail to sell an investment because they are holding it for ESG-related reasons and this could lead to an opportunity cost if a superior investment is overlooked.
Responsible investing is also a subjective term. There are no specific global standards or criteria that companies or funds must follow in order to be classed as ESG opportunities. This can mean individuals have holdings they believe are responsible investments, but ultimately fail to deliver on their goals. Moreover, some companies may inevitably latch onto the idea of outwardly appearing to be increasingly responsible in order to win customers and market share. In reality, their marketing campaigns may overstate the changes they have made to their business models.
Other firms may act responsibly in one arena but fail to do so in another. For example, they may have robust social policies and strong governance but operate in industries that have a negative impact on the environment. Unpicking the true impact of a company in all three areas of the ESG equation can be extremely challenging – and may not produce a clear result.
Another risk from investing in ESG funds and companies is the prospect of missing out on growth opportunities elsewhere. For instance, a business may have exceptional products that are set to deliver strong earnings growth. However, perhaps it is unavailable to ESG investors because it is not deemed a responsible firm. This could potentially lead to disappointing relative returns if, for example, sectors such as oil and gas or tobacco contribute a significant portion of the stock market’s overall returns.
Constant evolution in the ESG investment space
Looking ahead, ESG investments will experience change and evolution as per any market segment. A potential threat in this regard could be new technology that makes today’s investment opportunities significantly less attractive.
For instance, the rapid pace of change and investment within the sustainable energy sector, as well as a fluid regulatory regime, may mean present solutions to reducing carbon emissions are superseded by other technologies. This could make today’s clean energy funds and investments obsolete from an investment perspective.
Although the range of companies and funds that provide ESG investing opportunities is likely to rise, the choice available to investors remains relatively limited. As such, it may be more difficult to construct a diverse portfolio of responsible investments compared with a broader remit.
While this situation may change over time, as previously highlighted, the risks inherent in having a more limited range of investment opportunities remain in place at the present time.
Room to grow
While the popularity of ESG investments has increased dramatically in recent months, responsible investments make up only 3% of total industry funds.
The aforementioned risks could hold back investor interest in the sector in future. Indeed, they are potential threats that any investor in the responsible investing arena should seek to avoid, or reduce, where possible.
However, with consumers and investors apparently becoming more concerned with ESG factors following Covid-19, it would be reasonable to expect responsible investing inflows to rise in future. Innovation, regulatory change and strong governance could catalyse the performance.
As a result, holding funds that focus on the segment may well prove to be an efficient use of capital over the long run.
Robert Stephens is an independent financial journalist.
Further reading: ESG opportunities at forefront of a wave of new launches – Investors have a increasing array of ESG opportunities and eight products from four different providers have launched in the last month.