The waning enthusiasm for ESG investing

The increase in demand over the past few years for valued-based investments coupled with the growth of sustainable finance knowledge has resulted in a tsunami of ESG-related investment vehicles. For wealth managers, the challenge is not only to determine which are valuable, but to decide if ESG investing on the whole is a reliable source of returns.

Regulation has played a big role in shaping ESG investing as we know it. Sustainability-related disclosures in the financial services sector have set requirements for wealth managers, steering the way clients are on-boarded and how portfolios are managed. Wealth managers have significantly adjusted their processes and investment procedures in order to meet the increased scrutiny from regulators. However, when we look at the bottom line – helping clients to maintain and grow their wealth – have these measures been worth it?

Troubling signs

With the great number of ESG-related vehicles on the market and the highly developed regulatory landscape, an observer might be inclined to believe that such investments do help to maximise portfolio returns. However, the market signals are very mixed in terms of the overall profitability of ESG-related investments and funds.

“Some funds have performed well while others have significantly lagged behind their benchmarks, which has led some investors to question whether ESG investing is actually a viable long-term strategy.”

Teemu Riihijärvi

 

There have been some success stories. In the field of wind power, we can look to Vestas Wind Systems, a Danish company, which share price has been on a positive trend for the past 20 years. On the flip side, we can look at the car industry and EV as a more telling global indicator. Tesla, for instance, has suffered from major volatility in the past few years. Rivian, which manufactures high-end electric pickup trucks and SUVs – which are highly sought after, incidentally –, has seen its share price drop by nearly four-fifths since the company’s IPO in 2021.

According to Bloomberg, net outflows from ESG ETFs have totalled $361.7 million year to date, while net inflows totalled $32.1 billion in 2023. Thirty-six ESG-labelled ETFs in the Americas were liquidated last year, more than double the prior year, and these are just some of the closures of major ESG ETFs, according to the media and information provider.

ESG investing is showing signs of an S-curve, similar to any classic textbook case in the history of financial market trends. These investments go through a rapid infancy phase (partially due to regulatory and governmental measures) followed by a relatively robust growth of inflows.

Whether the negative signs are of a permanent nature or are just symptoms of temporary saturation, ESG investing cannot be declared dead. Whether ESG investments can generate solid returns to client portfolios remains to be seen, but they will play a crucial role as a building tool for portfolios going forward as they support the more general shift to global sustainable investing.

Addressing sustainability risk in portfolio management

Banks and asset managers need to adopt solid procedures to address and mitigate sustainability risk in asset management. At Banque Havilland, the sustainability risk in asset management procedure defines and details how the bank integrates sustainability risk into advice or portfolio management services, as required by the Sustainable Finance Disclosure Regulation (SFDR).

Three components of mitigating sustainability risk

For a portfolio not concentrated in a specific industry or country, the most effective and simple way to address and indirectly mitigate sustainability risk, as any other financial or non-financial idiosyncratic risk, is through sound portfolio diversification and construction. For that reason, Banque Havilland maintains a high level of diversification in the majority of its discretionary and advisory portfolios.

The most relevant sustainability risk is captured by the extra drawdown risk, and this can be controlled and mitigated by avoiding unintended large exposure to the lowest-performing quintile of the ESG scoring universe, the so-called “laggers.” Banque Havilland, through its Investment Committee, reviews on a semi-annual basis its allocations in discretionary portfolios and advisory portfolios to make sure that exposure to the lowest quintile is avoided.

A large portion of the sustainability risk can be indirectly mitigated by selecting funds that are subject to the SFDR, and hence need to have the related measures already put in place. The majority of Banque Havilland’s total discretionary portfolio is allocated to external funds domiciled in the European Union, meaning they already adhere to the SFDR.

(source: Paperjam)