Erica Hall.

While there have been some macroeconomic headwinds lately, ESG-focused funds are continuing to deliver better long-term returns to investors. 

The Fifth Estate spoke with Morningstar ESG analyst Erica Hall to find out some of the big market trends in sustainable investing.

There’s a lot of negative headlines of late when it comes to sustainable investing. 

Yet 55 per cent of ESG-focused retail and exchange traded funds (ETFs) have outperformed their broader market peers over the past five years, according to Morningstar’s latest Sustainable Investing Landscape for Australian Investors report.

It’s worth mentioning the Morningstar report only covers retail funds and ETFs, and does not include superannuation.

With gas, fuel and energy prices surging, stocks and sectors that broader market funds tend to invest more heavily in – namely energy – have tended to perform strongly.

Meanwhile, some of the sectors sustainable funds tend to focus on, namely healthcare and tech, have experienced a correction after a period of strong growth – especially through the pandemic. 

Yet despite these broader market conditions, over the past six months, 31 per cent of sustainable investment funds have still managed to outperform their peers within their respective categories.

Meanwhile, especially for people who don’t have large investments in funds, the big news is that investors have been pouring money into sustainable funds, while drawing down their investments in broader market funds.

At the end of the second quarter of 2022, the total value of assets in sustainable funds based in Australia and New Zealand stood at $38.749 billion, almost doubling in the two years since 30 June 2020.

Long-term sustainable growth

First, the basics. The sectors sustainable funds invest in will be different to the broader market. There will be a difference in their performance as a result.

“There are going to be certain stocks and sectors that are excluded, that are going to be certain stocks and sectors that the sustainable funds will overweight to, to meet their sustainable ESG objectives,” Hall says.

“The past five years, ESG funds have been doing really well. The long term story is still really encouraging in terms of performance. They’re keeping up with peers, and given what we know about decarbonisation as a global focus, the trend is clear.”

Because reducing emissions is a major focus for sustainable funds, they typically tend to invest in sectors that offer smaller carbon footprints, such as tech, or social outcomes, such as healthcare.

“Those two sectors have performed extremely well over the past few years. And then conversely, they are typically either underweight energy or they don’t hold it at all because of the carbon intensity of that sector and its reliance on fossil fuels,” Hall says.

“Energy actually hasn’t performed particularly well in the past few years. And so, these are that’s been a bit of a tailwind for the sustainable investment funds.”

Short-term energy price surge

Global unrest and the war in Ukraine have flowed through to higher energy prices, at least in the short term. In the longer term, these price surges are likely to accelerate the shift away from fossil fuels to renewables.

A good indicator for the surging share prices of energy companies is the S&P/ASX 200 Energy Index, which is up 23.6 per cent in the year-to-date, spurred on by surging oil and gas prices. 

In contrast, the S&P/ASX 200 Healthcare Index has returned negative 5.32 per cent over the same timeframe, and the S&P/ASX 200 Information Technology index is down 32.87 per cent.

“We’re having some short term challenges, there’s definitely some performance headwind. The sectors that typically ESG or sustainable funds are overweight in are correcting and the sectors they’re typically underweight in, such as energy, have been doing really well. 

“But this is a point in time, and I remain confident that energy won’t necessarily be the place to be indefinitely, unless they can actually transition to net zero and invest in renewables, and some energy companies are. But certainly fossil fuel assets have a limited life.”

More funds are being invested sustainably

On top of this, macroeconomic trends, such as higher inflation and interest rate increases, have created economic headwinds for many sectors across the economy.

Because of these factors, over the past quarter the rate of money flowing into both sustainable and conventional funds has slowed.

“Because we’re having these really challenging market conditions, flows have dropped off substantially. They’ve definitely softened and slowed across both sustainable investments and the broader market,” Hall says.

While investors continued to invest in ESG-related funds, despite the tough market conditions, they were drawing down their investments in conventional funds. 

In fact, conventional funds saw a massive $9.47 billion net outflow during the past quarter. 

The total amount of money investors drew down from conventional funds was greater than at the start of the pandemic, in the first quarter of 2020, by $5.592 billion.

In contrast, despite two difficult quarters in 2022, the total assets invested sustainably have increased by 13.53 per cent, compared to the second quarter of 2021. 

“The flows of the broader market have dropped off substantially, but the sustainable funds are still in net inflow,” Hall says.

“We’re seeing a really distinct trend in terms of the past two quarters, with the market volatility, in the broader market people are taking their investments out

“But in the sustainable investment market, people are still investing in, although not to the same extent as they have been. It’s a bit more muted. But they’re still actually positively investing into these strategies, which is completely different to what’s happening in the broader market

The total assets invested in Australasian-based sustainable investments have almost doubled in the two years since 30 June 2020.

“That’s basically showing that when investors are getting aligned to their values, they’re prepared to be a bit more patient and play the longer term game. And so I just think that’s a really interesting phenomenon that we’re observing in the data,” Hall says.

Are you an active or passive investor?

An interesting split in the world of sustainable investing is between “passive funds” – those that manage risks by excluding certain categories of investments – and “active funds”, which invest their funds to maximise their impact on a particular area of sustainability.

For passive funds, Hall says, the two of the most common exclusions in the Australian market are tobacco, and controversial weapons. 

Out of the 178 sustainable funds identified by Morningstar in Australia and New Zealand, 137 have some form of investment exclusion. 

Of these, 128 have restrictions on investments in tobacco and 121 limit investments in controversial weapons(companies that derive a significant portion of their revenue from nuclear weapons, land mines, cluster munitions, etc.)

“A lot of the rules based strategies will apply quite a number of exclusions. They might be completely exclusions or they might be minimising exposure through the amount of revenue generated by a particular controversial practice,” Hall says.

“So it might be that we’ll have just a 5 per cent of revenue exposure to gambling companies, for example.”

“The other end of the spectrum is assessing the impact and that’s when you’re positively investing in, for example, renewable energy sources, etc, where you really want to make a positive difference to the planet.”

Traditionally, active strategies made up the lion’s share of funds under management in sustainable funds, with 72 per cent of assets invested. 

However, when it comes to net flows, the trend appears to be reversing. In the second quarter of 2022, 84.7 per cent of total inflows were invested in passive sustainable funds.

“Increasingly, investors want to know the impact of their investments more broadly. They are demanding more granular reporting in relation to carbon emissions and social impacts, etc.,” Hall says.

“You’re seeing more and more detailed reporting coming through in relation to this, because it’s something that investors increasingly want to see. And as this industry evolves, we’re getting more and more data so that you can actually report on it.”

A growing trend of accountability

Looking to the future, increased accountability to investors and managing the risks of greenwashing are likely to become big focus areas for funds in the near future.

The ACCC and ASIC have recently tightened regulations around disclosures for ESG investment funds. Alongside this, the Modern Slavery Act is making businesses more aware of human rights violations in their supply chains.

“That is a really complex area to be able to report on, because it does require a look through global supply chains. I imagine most of the work needs to be done through direct engagement with suppliers and that can be really resource intensive and time consuming,” Hall says.

“There was some research that was undertaken by the Human Rights Law Centre that was saying that many companies are not identifying obvious modern slavery risks in the operation. But it is still in its infancy, and I understand that it’s quite challenging to get that information and report on it. 

“So I think that that will only improve over time.”

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  1. Long-term sustainable growth…….There is no such thing, growth cannot be sustainable to suggest otherwise is deceitful.