The rising interest in sustainability investing is closely linked to an awareness shift regarding the financial performance of this concept. In the late 1960s, investors started applying environmental and social criteria out of an ethical motivation. Today, this niche of morally-driven shareholders is joined by an increasing number of mainstream investors who are convinced that sustainability pays.
A recent study by WestLB Panmure gives further impetus to this development. The report compares the risk/return profile of sustainability investments to the mainstream market and shows encouraging results. Based on data for the pan-European Dow Jones Stoxx Sustainability Index (DJSI Stoxx) and the Dow Jones Stoxx 600 Index the authors assess the impact of sustainability on performance across different investment styles and various sub-periods. The results are impressive. Over all periods and within every investment style – large, mid, small, value and growth – sustainability has outperformed its mainstream equivalent.
The race is on to capitalise on this linkage and to translate sustainability insights into investment returns. Market participants are moving away from seeing the application of environmental and social criteria as a painful restriction of their investment universe. Instead, a growing number of portfolio managers is valuing sustainability assessments as an integral part of sound investment choices. The title of the WestLB report – ‘More gain than pain’ – concisely describes this new outlook.
The impact of sustainability on financial performance is closely intertwined with the growing contribution of intangible assets to shareholder value. Brand, knowledge, innovativeness, stakeholder relations, as well as the ability to attract and retain talented employees have become important levers of company success. As a result, financial metrics based on past performance offer investors only part of the necessary insights for company assessments. By adding non-financial and future-oriented indicators to existing valuation methods, a sustainability analysis completes the picture.
The point of departure for this analysis is a thorough understanding of economic, environmental and social trends that will shape the future of business in general and intangible assets in particular. Climate change and the resulting demand for a reduction in CO2 emissions, a shift towards renewable energy and innovative eco-efficient products are a case in point for that. Sustainability leaders in various industries are starting to manage the risks and opportunities triggered by this development. In the oil sector, leading companies have established divisions for renewables and set clear targets to lower emissions. Reinsurance companies are building up expertise to deal with a growing number of natural disasters. Firms in the auto sector are gearing innovations to mobility services with a lower environmental impact. Likewise, sustainability leaders in many other industries are seeking to understand the challenges of climate change on their business and act accordingly.
Climate change is but one of many trends that sustainability investors are taking into account to derive an appropriate set of assessment criteria for each industry. As a result, questions about environmental management systems, knowledge development, the reduction of CO2 emissions, brand management, stakeholder dialogues, policies on child labour as well as many other non-financial indicators are being added to the traditional checklist of stock analysts. In contrast to the purely ethically-driven strategies of the last decades, sustainability investors are neither focusing on negative screening nor on the exclusion of whole industries. Instead, they seek to identify leading companies in each sector based on economic, environmental and social criteria. In a report about sustainability investing published last October, Deutsche Bank highlights the move to this best-in-class selection as “the most significant change in overall methodology”.
With this approach, sustainability has become an investment style in its own right. The WestLB study shows that the integration of economic, environmental and social criteria is positively correlated with portfolio returns – regardless of size and traditional style factors. Sustainability is seen as an independent return driver that impacts on performance irrespective of a focus on large, mid, small, value or growth companies. WestLB gives further evidence to this conclusion by providing a regression model for the risk adjusted performance of the DJSI Stoxx. Accounting for market, style and size factors, the authors calculate the alpha to stand at a monthly excess return of 0.17% – which amounts to 2.1% on an annual basis. Their conclusion from these figures is straightforward: Sustainability is a distinct asset class which is likely to play a growing role in the future of investing.
The report also analyses the active risk of the DJSI Stoxx compared to the DJ Stoxx 600. With a tracking error of 2.26, the deviation risk lies in between the respective figures for active and passive mandates. In fact, it fits into the range of tracking errors that are applied to the growing number of enhanced indexing portfolios. WestLB shows that an optimisation can bring this tracking error further down to 1.32 and thereby move it close to the range for truly passive mandates. The possibility to apply the concept of sustainability without taking a high active risk against the mainstream benchmark, offers investors an interesting option for a first move into this market segment.
Several mainstream players have embraced this opportunity. A significant example is the Swiss Social Security Fund (AHV) which awarded a Sfr500m (e340m) mandate to State Street Global Advisors (SSGA) in 2001. Back then, this sum amounted to a third of AHV’s entire international equity portfolio. SSGA manages the money passively based on the Dow Jones Sustainability World Index (DJSI World) – the global equivalent to the pan-European DJSI Stoxx.
As pioneers such as AHV build up experience and raise demand, they are also adding to a better understanding of the links between sustainability and shareholder value. Reports such as the studies by Deutsche Bank and WestLB provide important insights into the characteristics of sustainability investments regarding performance and risk. With growing knowledge about this investment style, more and more investors will be inclined to join the field. Pension funds and other institutional investors will increase their allocation to sustainability portfolios. In fact, they can be expected to be key drivers in the overall growth of this market. Past developments provide assurance to trustees that the integration of future-oriented economic, environmental and social criteria does not run counter to their fiduciary responsibilities. A growing number among them now evaluates whether a sustainability-driven approach might even offer a perfect fit for their long-term investment horizon. Many will be convinced that it does.
Alexander Barkawi is managing director at SAM Indexes in Zurich