We know that the performance of socially responsible investment strategies can be an area of concern for our customers. It’s often assumed that investing with a socially responsible bias will incur trade-offs when it comes to performance, and potentially lead to lower returns. Here, we lay out how we expect our socially responsible portfolios to perform.
Why would we assume underperformance for socially responsible investments?
The origins of socially responsible investing were philanthropic, and largely focused solely on excluding certain investments based on moral considerations without focus on investor reward. This was typically termed ‘ethical’ investing. But there was often little consideration for how environmental, social and governance – or ‘ESG’ – factors could improve the rewards on offer to investors.
Additionally, many investments labelled ‘sustainable’ or ‘ethical’ can come with significant risk. For example, the financing of small-scale clean energy projects is typically long term in horizon, often with significant risk of capital loss. This means that these investments may not be suitable for a wide range of investors.
However, investors in traditional equity and bond markets now recognise that to ignore ESG criteria is to ignore opportunities and risks in these areas, that each have the potential to have a material effect on investor outcomes – or in other words, investor returns. Most investors have long had a framework to incorporate non-financial factors into their investment analysis, and the benefits of doing so are well understood. But the quality of non-financial data is improving, allowing us to better understand topics such as climate change, working practices, health and social impact.
Rather than assume that incorporating these factors into an investment process will lead to lower returns, there is increasing evidence that socially responsible investing could in fact lead to higher returns. The premise is simple: the companies that are best placed to operate successfully in the future are those with strong social responsibility profiles, that do business in a fair and progressive way, with a management team that addresses short-term risks while ensuring the company is positioned to adapt to long-term transformational changes – such as climate change.
And this premise is supported by academics and practitioners alike. A 2016 study by academics at the University of Minnesota, Harvard Business School and North Western university found that ‘firms with good ratings on material sustainability issues significantly outperform firms with poor ratings on these issues’1. Similarly, a 2017 State Street Global Advisors survey of 475 institutional investors found that ‘More than two-thirds (68%) say that integration of ESG into decision-making has significantly improved returns’2.
How have socially responsible investments performed?
Our investment team has conducted extensive studies to quantify the performance impact of a socially responsible investment (SRI) focus.
Our analysis has shown that there are no meaningful (statistically reliable) differences in the performance of strategies incorporating an SRI focus and those that don’t. Our studies used the same established SRI investment strategies that underpin many of the SRI-focused exchange-traded funds in our portfolios. These returns can be seen below, from the date of inception for the socially responsible indices.
Interestingly, since the launch of SRI indices studied, many of the SRI indices have slightly outperformed their non-SRI equivalents on a risk-adjusted basis. Most notably, when we study the volatility of emerging market equity indices, we observe that the volatility of the SRI emerging market index has been significantly lower than a non-socially responsible equivalent since inception. This intuitively makes sense given the higher focus on governance under a socially responsible approach, and that issues such as corruption and bribery are more prevalent in emerging economies.
A lack of meaningful long-term differences in return doesn’t mean that we always expect the returns of SRI indices and their non-SRI focused equivalents to be the same in the short term. In fact, we expect there to be short-term deviations in performance depending on the stage in economic cycle or market conditions. For example, the SRI emerging markets index has a structurally lower allocation to China than its non-SRI equivalent. This may cause performance to deviate between the two when the Chinese equity market experiences strong gains or losses.
It’s also worth acknowledging that most indices incorporating an SRI focus don’t have the same history as equivalent non-SRI market indices (many have only existed since around 2007), so our studies of performance have some limitation in time. However, we believe this timeframe is long enough to be reliable given it incorporates over 10 years of history, including the period of the global financial crisis.
Overall, we expect our SRI portfolios to deliver performance over the long-term that is equivalent to that of a similar portfolio without an SRI focus. That is, by incorporating a social responsibility focus we don’t expect there to be a performance trade-off for investors. Of course, the marginally higher cost of underlying fund fees for socially responsible portfolios will slightly reduce this return.
What about Nutmeg’s different portfolio styles?
When it comes to the difference in performance between Nutmeg portfolio styles, we expect any divergence to come from the difference in asset allocation.
Despite following the same investment strategy and process, the range of available asset classes that embed an SRI focus is more limited than with our current fully managed portfolios at present. With a different investment universe available to each portfolio type, the portfolios won’t carry an exact like for like exposure. Therefore, we expect them to diverge in time due to this difference. For example, high yield corporate bonds (or ‘junk bonds’) are not yet available with a social responsibility focus.
Much like in the example of exposure to China in emerging markets, this means we expect there to be deviations in performance between portfolio types over time, and our historical simulations have demonstrated a divergence in calendar year performance. But we also expect there to be more assets available with a socially responsible focus in the future, given the rapid growth in investments managed in this way, narrowing the differences in allocation.
What about performance projections for SRI portfolios?
We use the same methodology to calculate projected returns for all our portfolios. However, each projection is adapted to account for the difference in asset allocation and underlying investment style – in this case, a social responsibility focus.
Our projection calculations show that over the long term, we expect the socially responsible portfolios to deliver very slightly lower returns when compared to our fully managed portfolios, due to the difference in asset allocation. On an annualised basis, the impact of the lower returns is limited, with the maximum difference in any projected return and its non-SRI equivalent being just 0.2% lower per annum.
Critically, despite the slightly lower returns projected for the SRI portfolios, they do this with a lower level of volatility. This means there is no expected long-term trade-off in the risk-adjusted returns for socially responsible portfolios – ie. the return generated per the unit of risk taken isn’t lower.
As with all investing, your capital is at risk. The value of your portfolio with Nutmeg can go down as well as up and you may get back less than you invest. Past or future performance indicators are not a reliable indicator of future performance.
- Kahn, Serafeim & Yoon, ‘Corporate Sustainability: First Evidence on Materiality’, The Accounting Review, Vol. 91, No. 6, pp. 1697-1724.
- State Street Global Advisors ‘ESG Institutional Survey, Performing for the Future’, 2017.