It’s been a challenging year so far for socially responsible investing (SRI), with portfolios across the board having struggled to deliver positive returns. Though there are several factors at play which have impacted short-term performance, in our view the opportunities ahead remain largely positive for this still maturing theme.
This year has so far been volatile for both global equities and bonds generally, regardless of whether they fit within the SRI theme or environmental, social, and governance (ESG) filters. Covid constraints have now been lifted among most developed economies, which have been boosted by unprecedented stimulating monetary and fiscal policies. However, this has caused inflationary pressures that have been acute over the past 12 months, pushing central banks to act firmly and quickly on tackling price rises.
Add to the mix the war in Ukraine, and it’s clear to see how global supply chains have been interrupted. This is especially the case in commodity markets with energy, mining and agriculture-related industries and goods impacted, consequently pushing up input costs for global manufacturing and trade.
Another contributing factor, particularly in terms of global supply, is that the world’s largest manufacturing economy China is still deep in the trap of wide draconian lockdowns. The central government has temporarily stuck to a ‘zero-Covid’ policy, which has put control of the spread of the virus before economic growth.
The influence of oil and gas
So, why have SRI portfolios been among the hardest hit? ESG funds by design should have high standards (along with strict restrictions) for companies with regards to their different climate-related metrics. As a result, they tend to carry close to zero exposure to the oil and gas industries and much lower allocation to energy, materials, and other commodity related sectors than their comparable broader benchmarks.
As of the end of May 2022, the highest-risk Nutmeg SRI portfolio had 1.2% exposure to the energy sector, compared to 5.7% in our equivalent non-SRI Fully Managed portfolio – meaning SRI has only one-fifth of the Fully Managed energy exposure.
Aligning to a core principle of SRI, it’s preferable that investors should be offered the right to reduced exposure to those more carbon-intensive corporates facing enormous challenges in a world transitioning to lower carbon emission and usage of fossil fuels. However, in the short term at least, it’s been those kinds of companies that have been one of the few bright spots in terms of equity performance in 2022.
Commodities had already started the year positively before the outbreak of the war in Ukraine, which then exacerbated their growth dramatically with the price of Brent crude oil price jumping to near record levels, beneficial especially for the oil and energy majors.
While allocation to energy as a sector is largely limited in US equity indices, it’s a bigger part of other markets – especially the UK where BP and Shell are two of the largest listed companies by market capitalisation in the FTSE 100.
A narrower view
The impact of commodities on SRI portfolios versus non-SRI portfolios has been by far the dominant reason for the difference in performance between the two styles in 2022, but there’s more to it than just that.
Investing with an SRI slant means there are fewer available stocks to choose from. In practical terms this means that with most SRI ETFs held in Nutmeg portfolios the investment universe is narrower as they target the top 25% of companies with the highest ESG scores in each sector. The exception is the UK SRI index that we have held which targets the top 50% due to the overall size of the investment universe.
The ETFs also have a cap on maximum allocation to avoid excessive concentration – meaning they avoid holding too much in the largest companies in the SRI index in order to manage risk. The consequence of this is that the SRI-themed ETFs tend to have more of a bias to smaller companies than the non-SRI equivalents. In the UK, these companies tend to be housed within the FTSE 250 index of small and medium-sized companies, and this is an index that has underperformed versus the FTSE 100 made up of large and mega-cap stocks.
Within bonds, another factor for underperformance is that SRI ETFs tend to be more geared towards US rather than UK companies, which is due to the size of the investment universe when SRI filters are applied. As already discussed, UK equities have largely outperformed US equivalents so far this year.
The longer-term story
While SRI ETFs haven’t benefitted from the positive trend in commodity prices in 2022, looking at the performance over a more extended period, SRI indices versus non-SRI comparable indices remain largely positively with 2022 being more an outlier. The table below provides the excess return of SRI indices split by region versus their comparable broad regional index.
Table: Comparison of SRI vs. non-SRI % performance by region (2015 – 2022)
(% figures shows relative performance of SRI indices v non-SRI comparable indices)
Source: Macrobond, Nutmeg
Given the size of the commodity sector in the UK, it’s worth highlighting that it’s the only region where the SRI index underperformed on a total return basis over the past eight years.
With regards to commodities, geopolitical factors may continue to push prices higher. However, SRI performance isn’t only driven by these trends – oil prices went from $48 at the beginning of 2021 (low in historical context) to almost $80 by the end of that year, yet SRI indices still outperformed their non-SRI equivalents.
The outlook for SRI
Given how interest in SRI investing has grown so dramatically in recent years, there’s still reason to believe there’s plenty of room for further expansion. This year may well prove to be the first major period of underperformance that many investors in the theme have seen, yet SRI’s attractiveness over the long term remains real. Clients who invest with SRI principles in mind should, we hope, recognise that the retail investment world is making huge strides in the direction towards a more sustainable future, which should lead to better outcomes for all.
Risk warning
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 performance is not a reliable indicator of future performance.
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Pacome Breton
Pacome is an investment manager and head of risk at Nutmeg with more than ten years' experience in investment and risk management. He previously worked for a US family office and a large European asset manager and started his career at Société Générale in Tokyo. He holds an MSc in quant finance from Bocconi University in Milan and is a certified financial risk manager and chartered alternative investment analyst.Other posts by Pacome Breton
