Hint: there is a lot of Big Tech in them. But other factors matter too. Most important: it became fully mainstream.
Source: Morgan Stanley
The events of 2020 accelerated many trends that had been slowly on the rise otherwise. The most obvious is the wider adoption of anything online — from health care to shopping. Less visible, but still remarkable in 2020, is the attraction of sustainable investment funds.
This year, sustainability-focused and funds following environmental, social, and governance (ESG) metrics did quite well. An S&P index of climate-aligned companies beats the S&P 500 by 11%, with the gap widening over time. Overall, sustainable index funds are growing — fast.
All this shows: there is no clear trade-off between a fund’s financial returns and its focus on sustainability.
Should you just change your index funds to ESG or sustainable index funds then? Maybe. But not because high sustainability scores automatically deliver higher returns. It’s all about the methods to determine what “sustainable companies” are — scoring companies on environmental, social, and governance metrics.
Source: S&P Global
What makes index funds “sustainable?”
There are no clear rules around what index funds qualifies as “sustainable investment.” Unlike the European Union, the U.S. leaves it pretty much open to index providers to say if an index fund is sustainable or not. And index providers rely on rating agencies, who use different systems to rate companies on ESG. The SEC is actively looking at funds’ ESG labels, but until now, there is no standard as to what makes a fund “ESG” or “sustainable.”
Refinitiv and Morningstar have different methods, so a different top 10 of funds. Source: Financial Times (August 2020)
In a year where tech stocks flourished, ESG funds benefited from heavy holdings in the largest tech companies. Many ESG index funds might as well be about big tech. The point here is that ESG funds that are sold as investments in “sustainable themes” are not exclusively investing in companies with diverse boards that build solar farms or fight climate change.
Sustainable investing is like Normal investing
Rather than optimizing for high sustainability scores, the biggest ESG funds often try to stay close to the market. The result is that many ESG funds are made of portfolio companies that look similar to today’s tech-heavy S&P 500 — minus the worst performers on ESG. Looking at the weighted average ESG rating for the three large ESG iShares funds (7.7 out of 10), the difference is one point less than the “normal” iShares S&P 500 fund (6.7). How much does that matter?
First, it shows that sustainable investing is now mainstream. It’s 2021, and it’s risky for companies to be obsolete about their climate change impact, privacy violations, or racial diversity. Too many investors don’t like these risks. A study finds that 89% of millennials expect their financial advisor to thoroughly analyze a company’s ESG factors. All large companies have sustainability efforts, some just more than others.
Second, Environmental, Social, and Governance are fundamentally different parameters that not always align. It obfuscates the scores. Amazon has a relatively low environmental risk score (proactively reducing emissions), but a higher social risk score (controversies around warehouse workers, Alexa’s spying in your living room). Combining environmental and social risks into one “ESG” score offsets the different risks.
The obvious conclusion is that sustainability, often measured as ESG ratings, is complex.
Still… it’s not all show
The dominance of tech companies in sustainable funds still means sustainability is a relevant factor when investing in index funds. On a more fundamental level, investors care about sustainability — also because enough other investors care.
That sounds circular? It is, but it also implies that it has the attention of regulators wanting to avoid “greenwashing” and address false sustainability promises. As it became mainstream, companies can distinguish themselves by being smarter and more transparent about sustainability than the rest of their industry pack. In the end, more investors are looking to understand what’s behind the sustainability labels; it’s just part of common investment research now.