The best funds for a sustainable future

The coronavirus-induced crash was the most severe test for the stock market since the global financial crisis, yet some of the most resilient funds were those that focus on environmental, social and governance (ESG) issues. They are well-placed to generate some excellent returns as they should benefit from the long-term structural trend in favour of sustainability that the pandemic is sure to accelerate.

Funds that incorporate ESG factors in their stock-selection process have a long-term focus. Their managers believe that good governance, and societal and environmental sustainability will ultimately result in better returns. There is increasing evidence that they might be right.

Stocks that are in the top quintile of ESG research and ratings company, Sustainalytics’ ESG ratings have outperformed the S&P 500 since the fourth quarter of 2018 and have performed especially well, in relative terms, during the recent sell-off. This is further supported by the fact that the MSCI World SRI index, which is a benchmark of companies with strong sustainability profiles, has outperformed the MSCI World index during 2020.

Data compiled by Ryan Lightfoot-Brown, a research analyst at Chelsea Financial Services, shows that the percentage of ESG funds that outperform the average fund in their sector has gradually increased from 57% over 10 years to 72% over one year. This suggests that the performance of ethical funds has been steadily getting better.

Surviving the crisis

The environmental markets have been significantly disrupted by Covid-19, with near-term delays to climate-change policies expected and concerns about lower oil prices making it harder for alternative sources of energy to compete. However, ESG funds have still managed to perform relatively strongly.

Some of the short-term outperformance can be attributed to the sector positioning of these funds rather than the ESG credentials of their component stocks. This is because many tend to have high weightings to the health-care and tech sectors that have benefited from the pandemic and low weightings to energy and industrials that have both sold off heavily.

Lightfoot-Brown says: “This structural position has obviously been a boon, but as much as it’s a sector bias, it is also a factor bias. These funds have benefited from avoiding the highly leveraged, macro-driven companies and focusing on the quality growth companies that are in charge of their own destiny − stocks that an ESG approach naturally drifts towards.”

The market has been completely polarised in its overall performance, with higher-growth companies operating in sectors such as technology and health care outperforming traditional value plays for most of the last decade.

Adrian Lowcock, head of personal investing at Willis Owen, says: “The focus on good governance, the G in ESG, will have helped as it should mean that companies’ business models were more robust and the management intent on ensuring the company has a sustainable business model.”

The pandemic has highlighted the importance of having sustainable and diverse supply chains. It has also shown that companies with strong corporate governance and good business practices are best-positioned for the future.

A catalyst for change

ESG funds should be able to demonstrate their potential more significantly once the first phase of the economic recovery is complete, as there is an opportunity to ‘build back better’ by establishing a cleaner, greener economy that is more sustainable. 

A good example is Germany where the government has allocated €130bn of its recovery funding to have an electric vehicle (EV) charging station installed at every one of the 14,000 petrol stations across the country. Its commercial and public bus and truck fleets will also be electrified and the existing subsidies on EVs will be doubled. The scale of the investment reflects the EU’s policy that the economic recovery should be consistent with the ‘green transition’.

Another good example is South Korea, where the government has announced a ‘green deal’ to stimulate the economy and target zero net emissions by 2050.

These sorts of measures in favour of a greener economy should reward the environmental focus of ESG funds. For example, food supply-chain reorganisation should force growth in sustainable food, agriculture and testing markets, while concerns relating to clean air and sanitation are likely to drive pollution control, water treatment, renewables and electrification.

Commenting on the likely direction of many governments, including the EU in particular,  Rob Morgan, an investment analyst at Charles Stanley, says:

“They will be looking to promote electric cars and low-energy homes, using subsidies and taxes, which reinforces the moves markets are making away from traditional businesses and towards those at the forefront of global change.”

There are actually twin revolutions driving the transition: the all-embracing digital revolution and the growing power of the green revolution, with the two interlocked. The first has spread rapidly through the choices of consumers, while the latter is being advanced through spending plans, laws and taxes imposed by governments, as well as changes in attitude within society as a whole.

Ryan Hughes, head of active portfolios at AJ Bell, believes that the long-term trend of improving environmental sustainability is here to stay: “Governments are investing billions in creating a sustained shift in the environmental footprint of their nations. This can only be to the long-term benefit of those stocks that are focused on these areas, but as ever there will be winners and losers.”

The best open-ended funds

In the first quarter of the year, investors across the globe poured $45.6bn into ESG funds, which is remarkable given that the overall fund universe experienced net outflows of $384.7bn. There was a similar pattern in the UK, and many expect this area to continue to attract new money:

It’s often assumed that socially responsible investing means sacrificing performance, but I would argue the reverse is true. Attention to ESG factors has led to better insights and the early identification of key risks, as well as important opportunities, which is all contributing to better performance,” notes Morgan, who recommends Baillie Gifford Positive Change:

“It shares a number of characteristics with other Baillie Gifford global funds: a high-conviction, concentrated portfolio; a search for exceptional growth businesses; and a low turnover of holdings. The difference is this fund specifically aims to contribute towards a more sustainable and inclusive world, while generating strong returns.”

A good option if you are looking for UK exposure is Liontrust Sustainable Future UK Growth, which uses positive screening to invest in UK company shares that meet the managers’ rules for environmental and social responsibility.

As Morgan explains: “They aim to buy attractively valued companies that offer a product or service benefiting from environmental or social trends, or that can generate superior potential performance through strong environmental, social and governance credentials. The management team is highly regarded, having established a track record at Aviva and Alliance Trust prior to joining Liontrust.”

Hughes prefers the Liontrust Sustainable Future Global Growth fund that comes from the same stable. He says that it has a strong pedigree and is managed by a team that has been investing in this way for over 20 years.

Growing range of options

Lowcock suggests the Royal London Sustainable Leaders Trust where manager Mike Fox aims to provide above-average capital growth by investing in companies that have a positive effect on the environment, human welfare and quality of life.

Lowcock explains: “The fund invests predominantly in the UK, but with some allocation to the US and Europe. It provides exposure to companies involved wholly or in part in the manufacture of products, industrial processes or the provision of services associated with improving the environment and the enhancement of human health and safety.”

Lightfoot-Brown likes Pictet Global Environmental Opportunities, an environmental fund that invests in international equities, commenting:

“The manager has identified nine environmental challenges including but not limited to: climate change, ocean acidification, biodiversity and freshwater use. All companies within the portfolio must operate ‘within a safe operating space’ for each of these nine areas and actively contribute to solving environmental challenges.”

Unlike many of its peers, this fund goes well beyond climate change and addresses a full range of global environmental challenges. It has a well-designed process that focuses on less obvious, but no less important, environmental themes such as resource efficiency, less intensive agriculture and sustainable packaging.

Another option that he suggests is Ninety One Global Environment. It launched in December 2019 and only invests in companies that are contributing to the decarbonisation of the world economy:

“The portfolio has complete conviction with just 20-40 holdings and will have limited crossover with peers or its benchmark. It uses a proprietary screen to build the investable universe that is impressively comprehensive and dynamic to ensure the futureproofing of the strategy in the event of considerable technological enhancement,” he says.

There is also BMO Responsible Global Equity, which invests in quality, growth companies from across the world with a focus on sustainability. The managers are stockpickers with a long-term approach and they have the help of an independent sustainability team to ensure standards are maintained and backed up by strong engagement with company management post-investment.

If you prefer exchange traded funds, there are lots of recent additions in this area including a trio of new actively managed Fidelity Sustainable Research Enhanced Equity ETFs, as well as the Vanguard ESG Developed World All Cap Equity Index Fund and the Vanguard ESG Emerging Markets All Cap Equity Index Fund, with ongoing charges of just 0.2% and 0.25% respectively.

The best investment trusts

There are a number of investment trusts operating in areas such as social infrastructure, global utilities and wind or solar farms. These are mainly focused on income and aim to generate long-term, inflation-linked revenues from a mixture of government and private- sector contracts.

Shares in the renewable-energy trusts have been bid up by demand from ESG investors, but they have struggled recently due to the steep falls in long-term power price forecasts:

“This is a relatively new area with significant differences in approach so it’s really important that you understand what you are investing in and also the risks that come with it. They tend to trade at a premium to NAV so you need to be sure of what you are buying,” warns Hughes.

A good example is Impax Environmental Markets (LON:IEM), an £800m fund that aims to benefit from growth in the markets for the cleaner or more efficient delivery of the basic services of energy, water and waste. Its managers have considerable experience of investing in environmental equities and have built up a good, long-term track record, with a 10-year share-price total return of 209%.

The performance during the first four months of the year was more problematic with the small-and-mid-cap bias contributing to a 12.3% decline in the NAV, although the fund has since made up much of the lost ground. Its shares typically trade at a small premium to NAV and the main focus is on capital growth.

The investment-trust team at Investec has recently issued a buy note on the £525m JLEN Environmental Assets (LON:JLEN), which invests in a diversified portfolio of environmental infrastructure projects, including wind, solar, waste and wastewater.

Until recently, it had aimed to generate a high, sustainable quarterly dividend that rose in line with inflation, but the substantial falls in power prices have forced it to drop the inflation linkage like many others within its peer group.

Investec believes that the dividends of the renewables companies are relatively secure due to the high proportion of revenue that is derived from subsidies, and the fact that a significant amount of the money from the sale of energy has been fixed at higher prices. The shares are yielding an attractive 5.6%, but because of this they are trading at a 25% premium to NAV. 

ESG funds are growing in popularity and continue to attract investors who want their money to have a positive impact. Many of these vehicles held up remarkably well during the recent crash and the longer-term performance also seems to be improving as government and societal support increases. There is every chance that the pandemic will accelerate the structural shift towards a more sustainable future.

FUND OF THE MONTH

There are lots of new funds jumping on the sustainable ‘bandwagon’, but if you want to invest in this area, the safest option is to choose one that is long-established, so that you will know that ESG factors are embedded in its investment processes:

“As a broad-based starter to sustainable investing I’d look at the Stewart Investors Worldwide Sustainability fund,as they have a long track record of investing in this way. The fund invests globally with a clear philosophy, focusing on avoiding capital losses by investing in high-quality companies and it takes a long-term view,” explains Hughes.

It is a global equity fund that is co-managed by Nick Edgerton and David Gait, who conduct fundamental analysis of companies with a strong focus on the sustainability of their earnings and business models:

“There is also a preference for high-calibre management and healthy balance sheets leading to a bias to defensive growth shares. The extensive, independent and insightful research has delivered decent performance for investors since inception and we think it should continue to deliver sustainable returns,” advises Lowcock.

Stewart Investors Worldwide Sustainability invests in companies that are positioned to benefit from and contribute to the sustainable development of the countries in which they operate. At the end of May, it had a 52-stock portfolio that spanned all the main investment regions. It has generated a 148.7% return since inception, which puts it in the second quartile of the global sector.

Nick Sudbury: