With so many new and innovative sustainable investment strategies emerging, it can be difficult for investors to know what’s what. This overview can help.
In order to achieve the United Nations’ Sustainable Development Goals (SDGs), between USD 2 trillion and USD 7 trillion must be invested every year. But while many investors want to use their investments to help address the world’s biggest social and environmental challenges, it can be difficult for them to identify the best way to do so. In order to achieve their objective, it is important that investors are aware of the broad variety of sustainable investment strategies, their advantages and limitations.
While not exhaustive, the following overview provides an introduction to some of the most popular and impactful sustainable investing strategies in the market.
These are the most common sustainable investing strategies. They invest in companies or countries with leading sustainability practices in their industry or peer group, which enables them to better manage opportunities and risks related to sustainability. Major sustainability indices such as the Dow Jones Sustainability Index and the MSCI ESG Indexes follow these strategies.
The pros and cons: These strategies make it possible to build industry-agnostic portfolios with smaller deviations from the benchmark. On the flip side, this can lead to the selection of counterintuitive companies or sectors that are leading among their peers, such as the sustainability leaders in the mining or energy sector
These popular strategies often use the United Nations’ 17 Sustainable Development Goals as a point of reference. Sustainable thematic investing focuses on companies that make a positive contribution to people and the planet through their products and services. They enable investors to focus on topics they find meaningful, such as water, renewable energy and biodiversity.
The pros and cons: Sustainable thematic strategies help investors identify companies that are likely to be successful in the future because they are expected to benefit from major long-term trends that promise further growth. However, they are typically unconstrained and therefore generally do not invest in predefined sectors or regions. This means that entire industries might not be included, which tends to result in significant deviations from conventional benchmarks.
As the need to transition to a more sustainable economy intensifies, incumbent companies that harm society or the environment are facing increasing pressure to change and improve. This has resulted in growing demand for improver strategies that finance the transition to greener business models, as well as more robust sustainability practices and operations. Sustainable improver strategies are often complemented with robust active ownership, also called shareholder engagement, as a tool to catalyze progress and realize financial and sustainability benefits.
The pros and cons: Successful improver strategies are very impactful ways for investors to deploy capital and trigger positive change. However, they may fail to address material ESG issues and may therefore not deliver enhanced financial or sustainability performance. They can potentially also entail downside or reputational risks in cases where companies do not improve and sustainability risks materialize.
These strategies focus on financing sustainable projects or outcomes. Green bonds are a popular example, and are often used to fund projects that deliver environmental benefits such as renewable energy and clean transportation. Multilateral development bank bonds are another common dedicated asset. They can be an interesting option for investors looking to invest in projects with a positive social and economic impact in emerging nations. Other examples include sustainability-linked bonds, microfinance and commodities, such as gold, that meet high sustainability criteria.
The pros and cons: One of the advantages of sustainable dedicated assets is that the proceeds are used exclusively for sustainability purposes. This means that capital is channeled into financing or supporting explicit sustainability goals. One disadvantage, however, is that many of these assets require a third-party verification system and framework. Monitoring the credibility and transparency of proceeds is therefore key.
The US and EU have committed to reaching net zero carbon emissions by 2050, and China has stated it will do so by 2060. In addition, more than a fifth of the world’s biggest companies have committed to becoming net zero. All of this means that the economy is set to undergo major changes. Investors who are looking to mitigate risks associated with climate change and to leverage the opportunities arising from the transition to a net-zero economy might therefore opt for these strategies, which support the decarbonization of their portfolios and finance technologies that combat climate change.
The pros and cons: One clear advantage of net zero and low-carbon strategies is that they incentivize the economy to accelerate the process of decarbonization without causing an abrupt disruption to near-term results. However, they do have some have drawbacks, such as the need to verify whether the company is on track with regard to its net-zero targets and the risk of carbon leakage by pushing emitters to locations on less regulated markets of ownership structures, such as private ownership.
While all of these strategies can be beneficial if pursued on their own, investors might want to consider using a combination of different strategies. This enables them to address various sustainability topics while gaining exposure to different factors such as growth, value and quality. By combining strategies, investors can also harvest multiple risk premia and mitigate sector and factor biases, resulting in a more robust and better diversified portfolio.
For example, best-in-class strategies often create large capitalization and quality biases, whereas thematic approaches tend to have a growth and small/mid-cap tilt. Improvers benefit from exposure to industries that would often be dismissed or heavily underweighted in more traditional sustainability strategies, and dedicated assets provide important exposure to fixed income and alternative asset classes. In addition to these benefits, investors who pursue a combined approach can also choose to create dedicated satellite portfolios that focus on their specific sustainability objectives while further enhancing diversification.
Sustainable investing is not a passing trend - it is here to stay. And as it evolves, it is shifting to more sophisticated strategies that can be applied to a growing number of asset classes. The wide range of strategies available today not only caters to investors’ different needs and preferences, it also supports the real economy’s transition as it introduces more sustainable practices and business models.
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