Sustainable forms of finance and investing are on the rise and the industry for sustainable mutual funds is growing massively. The trend comes in different forms, and international standards have not been properly set yet.

The trend of sustainable investing

The sustainability aspect of the finance industry has grown rapidly over the last years. It is mainly defined as investments guided by ESG principles.

Firstly, E stands for environmental, which addresses topics like greenhouse gas emissions, renewable energy, energy efficiency, resource depletion, chemical pollution, water consumption by firms and certain projects.

Secondly, S for social stands for community-related aspects such as the improvement of education and access to health services, human and labour rights and health standards in the workplace.

Thirdly, G like governance is about management and culture of firms. It mainly deals with issues of transparency such as the board being an independent overseeing body. Governance is especially important in the case of sovereign bonds, where criteria such as death penalty and corruption of respective states are some of the most important in deciding their sustainability rating.

Another term that relates to the idea of sustainable finance is SRI, Socially Responsible Investments.

Different approaches to ESG incorporation into investment decisions

There are different approaches of incorporating these principles into investment decisions for investors. Eurosif has defined the following:

  • Exclusion: excluding specific types of investments from the universe. These can, for example, be firms that produce weapons, tobacco or pornography. This method is especially prevalent in ecclesiastical investment strategies by churches that define their own ethical forms of investments.
  • Best-in-class: defines a peer group and picks the best-performing forms of investment from a sustainability aspect.
  • Engagement and voting: this long-term approach seeks to influence decision-making in a more sustainable way by making use of shareholder rights and actively communicating with executives.
  • Norm-based screening: using international standards and norms such as ISO 14001 to set benchmarks for environmental performance etc. 
  • Impact investing: such as microfinance, community investing and social entrepreneurship funds to generate, generally speaking, social and environmental impact and drive change in many forms.
  • Sustainability themes: investing in sectors that inherently contribute to climate change mitigation or establishing more sustainable forms of production and consumption.
  • Integration: is the general case of the inclusion of ESG and similar criteria into the investment decision process.

The myth of underperformance

There exists prejudice against responsible forms of investing with the thought in mind that you’d take chances away from your investment universe and miss opportunities for higher yield that way. However, studies such as a Mercer/ENUP meta-analysis or Steinbeis’ research centre’s paper suggest that the hypothesis of financial underperformance of sustainable funds should not be accepted. Although the investment universe does get smaller when investing according to responsible criteria, the biggest argument for why it is not hurting your returns is that considering ESG topics can protect and enhance your yield, as PwC argues in its study ‘Responsible Investment: Aligning Interests’. An example for this are climate risks that are already addressed with this philosophy. Therefore, fund managers tend to ascribe a ‘double yield’ to sustainability products, as they generate financial and non-financial returns.

Who decides on what is sustainable?

One of the biggest issues of the industry is the definition of terms like sustainable, responsible etc. There are many labels and organisations trying to classify firms and respective financial products but not one internationally accepted metric. This has lead to ‘greenwashing’ of products as a marketing strategy. The EU has therefore set a strategy out a plan in its 2018 Action Plan on financing sustainable growth and has released a Taxonomy aiming to define a sustainable economic activity. Further, it wants to classify how much of a financial product goes into financing these and seeks to establish an EU Green Bond standard label which would require 100% of funds to go into above-mentioned activities. It is part of the Commission’s 2018 Action Plan on financing sustainable growth which intends to tackle climate change with the help of the financial sector.

Trends in the industry

After growing 1% in 2018, the market for sustainable funds has now risen 15% to $52bn during the first half of 2019 only according to Fitch ratings. It is still relatively small compared with the $6tn money market sector but shows great potential. The number of sustainable mutual funds has expanded to 3,955 since 2012, an increase of 80% and assets under management in ESG-oriented mutual funds has grown to $1.8tn according to data provider Morningstar.

The industry sees a lot of expansion when it comes to hiring figures: Almost every large European asset management company has roughly doubled their size of sustainable investment divisions in the last years and are adding sophisticated technology tools to their departments to capture the trend.

The demand for these products has also grown with millenials as a growing proportion of the investment population. This group is typically drawn to more ethical forms of finance and investing. According to research firm Cerulli Associates, more than two-thirds of investors younger than 30 prefer making investments with a positive social or environmental impact and customers under 40 are generally more interested in the topic of ESG investments than the older population.

All in all, ESG investing is on the rise and an industry with huge potential. It stands for a general shift in public opinion about the responsibility of firms not only to their shareholders but to their stakeholder communities as well. Since everything a firm does undergoes scrutiny in the investment process, it is firms that have the proper assessments already in place and a sustainable business model written in their DNA that profit the most. It is also interlinked with the UN’s Sustainable Development Goals that try to promote a more sustainable global way of living, doing business and consumption patterns.