The Right (and Wrong) Questions About Returns and Sustainable Investing
By Carola van Lamoen, Head of Sustainable Investing at Robeco
Many people treat sustainable investing and generating returns as two mutually exclusive elements. Asking whether it is better to generate performance or invest sustainably is the wrong question, because it poses a false dilemma. Any investment product aims to generate performance in line with the client’s expectations. Therefore, a more correct question is about risk-adjusted return criteria and how the client’s risk budget can be used to integrate sustainability preferences.
Focusing solely on financial returns misses the fact that many investors also want to reduce risk and have a positive impact. First, there is a need to assess the financial impact of sustainability issues. Second, investors are increasingly willing to have portfolios aligned with a positive impact. Here, we have less of a dilemma than an optimization problem: what is an investor’s performance goal, how much risk are they willing to take, and to what extent should sustainability be integrated?
Integrating sustainability is an important source of value
ESG factors can act as an “early warning system” for risks that are not yet reflected in asset values. Climate and transition risks can negatively impact future returns for companies and lead to stranded assets. Taking into account financially material ESG issues therefore allows for more comprehensive assessments and valuations, and also for the early discovery of investment opportunities.
However, there is no one-size-fits-all approach. Sometimes ESG issues are central to investment decisions, and other times they are irrelevant. In corporate bonds, for example, ESG analysis flags hidden corporate risks that influence investment decisions in about 25% of cases. In equities, the impact is greater, with over 50% of cases influenced by ESG issues. These findings make sense given the long-term nature of ESG analysis and the fact that value stocks have an indefinite time horizon. Corporate bonds, on the other hand, tend to have shorter time horizons.
Aligning portfolios for positive impact
The starting point for ESG integration is financial materiality. Investors can decide to allocate capital to companies that have a positive impact, while diverting it from those that cause (significant) harm. In addition, engagement and voting can lead to positive change in the companies that receive investments. Of course, when assessing investments based on impact materiality, investors need to ask themselves what impact their investments have on society at large. This approach helps them better prepare for tomorrow. By monitoring regulatory action, we expect that in the future, companies will be required to bear the cost of negative externalities such as carbon emissions and biodiversity degradation, which will therefore have a financially material impact in the future. In this case, it is crucial for an investor to understand the possible consequences of such decisions on investment performance.
Further research is needed
The investment industry certainly needs to conduct more research on the relationship between financial performance and various sustainable investing approaches.
When it comes to integrating sustainability and investment performance, it is essential to ask the right questions: What are the investor’s sustainability preferences, what are their financial goals, and how can they best be combined? Adding certain sustainability preferences to an investment strategy is not dissimilar to taking into account other preferences, such as those related to regions, currencies, and liquidity. There is no reason to treat them differently.
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