Preparing portfolios for a sustainability storm

• Sustainability is transforming our lives as we transition to a low carbon economy. Investors, too, are increasingly adapting their portfolios for this change
• COVID-19 coincided with a surge in interest in, and holding of, sustainable investments – and this considerable momentum has continued into 2021, with the sector flourishing
• Yet many new market entrants may struggle to invest effectively – from failing to unpick the jargon or guarding against greenwashing. There’s also the risk of an ESG bubble bursting
• Sustainable investing may be facing a turbulent period. Investors should prepare their portfolios to account for potential government policy changes and the impending market conditions.

While sustainable investing is rapidly growing, challenges are on the horizon. As a megatrend, it will endure. But investors should consider how to position portfolios to get the best from the short-term risks and opportunities.

The mid-point of the year is a natural moment for investors to pause – reflect on the market’s progress and trajectory – then set course for the second half of the year.

Sustainable investing, carrying considerable momentum from 2020, has flourished in 2021. With (hopefully) more success overcoming the pandemic and attention from the COP26 global climate summit in November, flows into sustainable investing may accelerate further in coming months.

For investors, sustainability and sustainable investing increasingly have to be part of how they invest. Yet, rapid growth and enthusiasm, in a still immature market, likely means a turbulent period ahead. Investors who understand its principles and practices can position their portfolios to benefit in both the short and long term.

Sustainable investing is here to stay

It is not only the pandemic that is creating a “new normal”. Sustainability is both driving, and being driven by, forces that are transforming our lives. Consider some of them.

Governments are embracing, as well as encouraging, sustainability. Foremost, their focus is on climate, with 137 countries having made net zero commitments¹. But their attention on sustainability now extends to other environmental issues, such as biodiversity or environmental footprint, as well as social issues such as education, structural inequalities or healthcare.

Linked to this, the financial industry faces further sustainability-linked regulations. To ensure the concept is incorporated in investment decisions and corporate reporting, regulators are generally taking a “comply or explain” approach. Translated, this provides a grace period for organisations to conform to new standards. With President Biden’s administration executive order in May², now every major market has, or will have, some requirements around sustainable disclosures and practices.

Even without this pressure, institutional managers, who control a majority of global investment capital, are committing their businesses to sustainability. Furthermore, meta-research³, and moreover the lived experience of 2020, demonstrates the materiality of ESG issues on financial performance. In this case, incorporating sustainability becomes a fiduciary duty, not optional add-on.

In wider society, consumer priorities and demographics are shifting. Consumers increasingly care not only about the product or services they receive, but how sustainably these are made or delivered. The voices and values of millennials, now estimated to be 23% of the population⁴, and 50% of the workforce⁵, are driving social movements and workplace culture.

Even with this cursory listing of these forces, the trajectory of sustainable investing is apparent. It can no longer be questioned as a fad or fashion. Rather, it is integrating into society and therefore, should be in how investing operates.

But there are headwinds coming

However, this is not a declaration that sustainable investing is fully established. Instead, it is a warning it may enter a difficult period during the second half of the year. This will be due to several factors.

First, the ongoing, simplistic view that the field is homogenous. Funds that apply ESG filters across all industries are being grouped with highly thematic sector-focused funds. This, as explained in “Unpicking the jargon of sustainable investing” in June’s Market Perspectives, will mean that if certain sustainable investments perform poorly, the entire movement may be perceived to be.

Similarly, overreliance on ESG ratings as an absolute and constant determination of quality. High ratings do not bestow permanent sainthood for a company. ESG ratings provide an algorithmic judgement based on backwards-looking, available and generally self-reported data on how well a company manages its materials environmental, social and governance risks.

Even if a company deemed well-run based on ESG factors, this doesn’t assure it will be financially successful. Other factors, such industry dynamics, effective strategy and execution, and “in favour” from a market cycle perspective, influence financial performance.

Flows to sustainable funds are not permanent

Second, highly liquid capital that has rapidly flown in, can easy flow out. This raises the question of is there an ESG bubble?, as posed in March’s Market Perspectives, particularly the case with sustainability-linked thematics, such as renewables.

As MSCI analysed, energy efficient stocks have been a crowded trade, at comparable levels to technology stocks in 1999 dotcom boom⁶. Some of that pressure was released in the pullback seen in the sector since March. But it does demonstrate the momentum and volatility factors that can push sustainable thematics upwards, can also drag them downwards in different market conditions.

Greenwashing risk

Last, the risk of greenwashing is increasing. The multitude of new entrants may have enthusiasm, but not necessarily knowledge or skill to invest effectively. Additionally, marketing of the positive aspects of sustainability may mean investor expectations exceed reality. As we warned in “Greenwashing: caveat emptor” in April’s Market Perspectives, without knowledge or a guide, investors may struggle to navigate the field and select the most appropriate products amid the cacophony of sustainable marketing.

These indicators, emerging at the end of 2020 and building during first half of this year, point to challenges ahead. As advocates for both the movement, and our clients, how should investors plan and position their portfolios?

Focus on managing short-term sustainability risks

In the short term, investors can understand and prepare for risks driven by likely structural changes and the impeding market conditions.

For example, analysis of current governmental policies and plans demonstrate we are not on track to meet Paris Agreements of two degrees centigrade, let alone the 1.5 degrees ambition⁷. Governments will have to respond. Addressing climate change is not a campaign pledge that can be quickly dismissed.

The longer governments delay the more severe the implications. The UN’s COP26 in November, and preceding months, provide the ideal backdrop for countries to increase their ambitions. Therefore, investors might review portfolios for the transition risks and carbon intensity in advance of this inevitable policy risk. Separately, as highlighted in “Can the economy sustain its strong rebound”, investors face the risk of rising inflation and need to reassess investments, and entry points, accordingly.

For specific sustainable themes and sectors, such as renewables, electric vehicles and mobility, much of their valuation is driven by potential growth. In an inflationary environment with higher discount rates and with market rotation, these sectors may fall from favour. This may require patience from investors during a downturn. Or it may provide a more attractive entry point for those who missed an earlier opportunity and find the potential volatility acceptable.

Look to the horizon to set a sustainable course

In the short term, sustainable investing may face a turbulent time. Potentially volatile and inflationary markets, and hype that rises until it pops, may provide a challenging environment.

While this journey is unlikely to be smooth as a megatrend, sustainability has momentum, direction and causal effect. Investors who can prepare themselves and portfolios for any short-term challenges are likely to be well positioned for the long term.