Surge in sustainable fund flows signals tipping point

• US investment flows into sustainable funds have rocketed by over 250% in 2019 reaching $21.4 billion in new money – almost four times the $5.5 billion in 2018
• Europe broke new ground with record inflows into sustainable funds with total assets reaching $744 billion (EUR 668 billion) by year-end, with active management remaining more popular over passive
• Green and climate bonds have reached new heights with $257 billion in new issues as more members of the financial community sign up to the Principles of Responsible Investment

The drive towards sustainable investing surged in 2019. In Europe alone, investors poured a record-breaking $133.6 billion (EUR 120 billion) into sustainable investment funds throughout the year, data from investment research firm Morningstar reveal. More than a third of the year’s inflows – $52.7 billion (EUR 47.3 billion) – came in the final quarter, meaning it is likely for a similar trend to occur in 2020.

The story proved similar in the United States, where estimated net flows into open-end and exchange-traded sustainable funds (ETFs) available to US investors totalled $21.4 billion in 2019. This figure is almost four times the $5.5 billion in 2018 and brings up the total stock to $137.3 billion.

Despite net fund flows into sustainable funds in the Europe area being nearly five times higher than in the US, the trend towards sustainable assets as well as the upsurge in 2019 are in line in both markets.

European sustainable assets held by 2,405 sustainable funds surveyed by Morningstar reached $744 billion (EUR 668 billion) at the end of 2019, marking a 56% increase from the previous year. This upturn is a result of inflows, market moves and an increase in products such as 360 sustainable funds launched in the year. Additionally, 50 of the sustainable funds launched in 2019 had specific climate-oriented mandates.

It is important to note that, to avoid greenwashing, the funds included by Morningstar do not include those that consider environmental, social and governmental (ESG) factors in a limited way. Rather, the data is based on flows into mutual funds and ETFs that meet one or more of the following criteria: (1) integrates ESG factors into the investment processes, identified as ESG integration funds; (2) engages in sustainability-related investment themes, labelled sustainable sector funds; or (3) measures sustainable impact alongside financial returns, categorised as impact funds.

The Global Sustainability Alliance (GSIA) estimates that more than $30 trillion were allocated to sustainable strategies in 2018, ranging from $17.5 trillion in ESG integration to $500 billion in impact investments, without accounting for negative screening strategies. However, it has been noted in Morningstar’s data that 2019’s record stocks remain at less than 1% of the $20.7 trillion held of the mutual and exchange-traded funds universe in the US.

Total discretionary assets under management (AUM) of the top 500 asset managers in the Thinking Ahead Institute rankings amounted to $91.5 trillion at the end of 2018, down 3% from the end of 2017, while AUM under ESG mandates actually rose by over 23% over the same period.

The impact that portfolios have on the world is becoming inextricable to the world’s impact on portfolios. Proof of this is how stock markets are progressively launching new product offerings and services as a response to the rising demand for ESG information as well as the growth of green bonds and other sustainability-focused debt products.

In addition to providing guidelines on how sustainability labels translate into application of the financial products involved, exchanges are communicating these methods through sustainability and integrated reporting. The Stock Exchange of Thailand is a pioneer in this area with its sustainability reporting practice dating back to 2001.

ESG indices were the first sustainable products adopted by financial markets with the goal of providing a common platform to regulate and standardise ESG and sustainability labelled products. More recently, however, stock exchanges have worked with the Sustainable Stock Exchanges Initiative to launch specialised labelling and sustainability-focused bond segments to make these products more accessible. Key developments include:

(1)   Mandatory listing rules requiring ESG reporting;

(2)   Published written guidance on ESG reporting;

(3)   An annual standalone ESG report or integrated into their financial report;

(4)   A sustainability-related index specific to the market the exchange operates in, which may include environmental, social or ESG indices as well as specific themes, including low carbon or general sustainability indices; and

(5)   A dedicated green or sustainable bond segment providing rules and regulations allowing for sustainability bonds to be listed, and provides a separate segment for listing, making the bonds easy to find and identify.

The growing number of sustainable products and services launched by stock exchanges has started to provide the infrastructure necessary for financial products to work towards tackling climate and sustainability issues at scale. Certified Climate Bonds and Labelled Green Bonds, as recognised by the Climate Bonds Initiative, are continuing their exponential growth momentum. Newly issued bonds hit a record $257.5 billion in 2019, whilst new issues are predicted to reach $350 billion in 2020.

More than $100 billion in green and sustainability-linked loans has been announced so far in 2019, according to data provider Refinitiv, double the volume raised in 2018. Unlike green or sustainability bonds, these loans are linked to a company’s ESG performance rather than to a specific project qualifying under the loan.

Similarities exist between ESG ratings and credit ratings for companies, as the ESG risk and performance may be linked to the interest rate of the loan and/or tied to environmental conditions, such as meeting targets for reductions in CO2 emissions. This provides a relatively simple, direct and tangible financial payoff for companies to better manage their ESG risks.

Rapid growth in market share for index providers, enhanced opportunity for active managers

Active funds have remained more popular in Europe in terms of flows into sustainable funds and ETFs, but in the US, 60% of the money flowed into passive funds in 2019 – a higher proportion than into active funds for the third year in a row. There was still room for $8.67 billion which flowed to active managers in the US, perhaps indicating confidence in active managers to affect change.

Yet, big index investors have not always remained passive and have also deployed their votes on ESG-related issues. For example, State Street Global Advisors may vote against boards that have consistently lagged peers’ ESG ratings.

Active managers have a variety of strategies to enhance returns, including having some negative exposures related to their understanding of ESG metrics – by either engaging with the company to seek improvements or by going short on bad companies to generate attractive risk-adjusted returns – to reduce portfolio volatility or to hedge market risk.

Such shareholder advocacy for value creation can be part of a long/short global value ESG strategy integrating long-term investments in undervalued high-quality public companies, while at the same time selling short the shares of companies deemed not to be on an improvement trajectory. An example of this would be a non-transitional fossil fuel company or a company with consistent poor corporate governance indicators.

While certain ESG criteria can be quantified and input into a passive model with the help of artificial intelligence (AI) – for instance, the average age of the board – there are also opportunities in human interaction. One example of this is through understanding the quality of a management team and recognising whether they are looking to create sustainable long-term value, even if their ESG metrics are currently below the benchmark.

In many respects, ESG is more about mitigating value at risk rather than producing real change. In some cases, big technology firms dominate the portfolios of ESG-labelled funds. If investors really want to affect change more directly, then impact investing and specific thematic funds should be used. The designated theme can incorporate at least 50% of assets in the portfolio to the designated cause while still allowing for market hedging and diversified risk with other stocks.

Sustainability regulatory risks increasing

A total of 242 names in the Thinking Ahead Institute’s 2008 list of 500 largest asset managers did not make it into the 2018 list – a possible indicator of the importance of sustainability. In the same survey, 57% of asset managers said that they had experienced an increase in regulatory oversight.

Investment portfolios’ companies need to be assessed in terms of their oversight management, due diligence of a company’s strategic direction on supply chain management oversight, as well their operational and transaction aspects when assessing supply chain management controversies.

Regulation is affecting investors further through the EU Sustainable Finance Action plan and other leading directives from Europe. This has encouraged greater transparency as well as a stronger alignment of capital markets with key issues regarding the environment, through a common taxonomy, a green bond standard, development of products, benchmarks and disclosure. Such mandates are now also moving towards social classification, which may be elevated to include defining and redefining the duty of care of companies beyond disclosure and reporting.

One of the challenges of ESG is that it is a broad topic, with high-level terms requiring from a materiality perspective granular and specific data and guidelines to relate to specific circumstances. The Corporate Human Rights Benchmark, the World Benchmarking Alliance and SDG Benchmarks are providing granular level alignment frameworks. Further developments will require the creation of new products like benchmarks.

The Financial Stability Board’s Task Force on Climate-related Financial Disclosures (TCFD) has developed voluntary climate-related financial risk disclosures that companies can use in providing information to investors, lenders, insurers and other stakeholders. It provides a roadmap to work out how much off-balance sheet is at risk from a transition to a low carbon economy by navigating from identification of risk and target setting to scenario analysis and then stress testing.

In China, financial regulators are currently working on a framework for mandatory disclosure, which requires all domestically-listed companies to release ESG reports based on new requirements beginning in 2020.

There is certainly an element of survey fatigue stemming from the growing demand to integrate ESG and the explosion of ESG rating and credit providers. To combat survey fatigue, companies can consider providing a live depositary of ESG data on their website for rating agencies, regulators and other service providers to access, offering real-time updates which can more efficiently utilise artificial intelligence, rather than relying on a periodic sustainability report.

For those seeking a starting point for integrating ESG, they can align with the standards suggested by the International Finance Corporation – the private sector arm of the World Bank Group – or the UN Principles for Responsible Investing (PRI), which are growing in adoption across the investment spectrum.

The PRI has implemented minimum requirements for existing and future asset owner and investment manager signatories. Failure to meet these requirements over a two-year period following engagement with the PRI would result in delisting. The three requirements are: investment policy that covers the firm’s responsible investment approach which covers more than 50% of AUM; internal/external staff responsible for implementing responsible investment policy; and senior-level commitment and accountability mechanisms for responsible investment implementation.

Islamic finance based on Sharia principles is growing and its ethical community and stakholder investment principles are well aligned with ESG intergration. Further product and infrastructure innovation could unleash new asset types at scale. With sustainable investing approaching a tipping point in developed markets, Islamic finance is breaking ground. Indonesia issued the world’s first sovereign green Sukuk in 2018 and Dubai’s Majid Al Futtaim issued the region’s first corporate green Sukuk last year.