It’s easy to lose sight of long-term perspectives amid the extraordinary market moves in recent weeks. We prefer looking beyond short-term volatility and keeping abreast of longer-term trends, such as a move to sustainable investing: a structural shift in investor preferences leading to large and persistent flows into assets perceived as more resilient to sustainability-related risks such as climate change. Investors re-balancing portfolios after the recent risk asset selloff may consider leaning into sustainable assets.
We see a sustainable investing wave playing out in financial markets over the coming decades, remaking economies and industries as capital is reallocated to sustainable assets. This year’s fund flows may offer a miniature version of this shift. Sustainable exchange-traded funds (ETFs) have kept attracting assets this year, while traditional ETFs have seen heavy outflows in the market selloff. See the chart above. Net inflows into sustainable ETFs totaled $14 billion as of March 24, already more than half of 2019’s full-year figure, our data showed. To be sure: The total assets under management of sustainable ETFs are just 1% of that of total ETFs, and flows to sustainable funds are still very small compared with those to traditional funds. Yet the growing interest offers a glimpse of what may lie ahead: a significant structural shift toward sustainable investing, driven by broad societal preferences. As a result, we see portfolio re-balancing in the current environment as an opportunity to substitute some traditional assets with sustainable ones, with an eye on potential long-term benefits.
How should we expect sustainable investing strategies to perform over the long term?
Skeptics have long argued the following: 1) Financial markets are efficient, so if sustainability matters it should already be reflected in market prices; 2) if investors care about sustainability, they should be willing to accept lower returns by paying a premium for “green assets”; 3) conversely, investors will earn a greater return as compensation for owning higher-risk “brown assets.” This logic leads to the conclusion that we can simply ignore sustainability: Tilting toward green assets will be costly and owning brown assets will offer relatively higher expected returns. We disagree.
Why? Financial markets are imperfect at pricing information about the far-off future, even when the structural shifts are well understood. Think of slow-moving demographic trends such as population ageing and its implications for asset prices. When we complete the transition to a low-carbon economy in which sustainability will be fully embedded in marketing pricing, assets backed by high sustainability will be more expensive – while other assets will have become cheaper or disappeared altogether, in our view. Sustainable assets should earn a return benefit during the long transition to this state, in addition to greater resilience against risks such as physical disruptions from climate change. This implies the conclusion that sustainable investing requires sacrificing returns is a myth, in our view. Sustainable investing will likely carry a return advantage over years and decades, as we detail in our recent paper Sustainability: the tectonic shift transforming investing.
This phenomenon could already be playing out to some extent this year. We studied the performance of the MSCI World SRI Select Reduced Fossil Fuels Index as a proxy for sustainable global equities since late January, when China first acknowledged the coronavirus outbreak. This index outperformed its parent (MSCI World) over the period, likely due to its reduced exposure to the hard-hit energy sector. Our analysis of MSCI’s back-tested data suggests the index also outperformed during the market selloffs of mid-2015 and the fourth quarter of 2018. Moreover, other broad ESG equity indexes slightly outperformed their traditional counterparts in developed equity markets over the recent market plunge, we find.
Flows into sustainable assets are still in their early days, and we believe that the full consequences of a shift to sustainable investing are not yet in market prices. This implies a return advantage may be gained over the long transition.