It’s been a gruelling year so far for financial markets, including for equities. And sustainable indices have had it even harder, having underperformed the overall equity market. Critics of sustainable and ESG investing have been emboldened by these recent market developments, arguing that doing good seems to equate to losing money. We ask portfolio managers Chris Berkouwer and Michiel Plakman if the field of sustainable investing is now facing a reckoning.
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Erika van der Merwe (EM): It's been a grueling year so far for financial markets, including for equities. And sustainable indices have had it even harder, having underperformed the overall equity market. Critics of sustainable and ESG investing have been emboldened by these recent market developments, arguing that ‘doing good’ seems to equate to ‘losing money’. Is the field of sustainable investing now facing a reckoning?
Welcome to a new episode of the Robeco podcast
EM: My guests to discuss this are portfolio managers Chris Berkouwer and Michiel Plakman. Welcome.
(Hi, good to be here)
EM: For context, how serious has the underperformance been of sustainable equity indices and sustainable products?
Chris Berkouwer (CB): Well, we've definitely seen an underperformance of most sustainable strategies, probably more so on the more impact-related sustainability strategies. I think that the mainstream ESG strategies have fared a bit better in this environment, but it's indeed the first time in years that we've seen underperformance of sustainable strategies on average.
EM: Can one say in brief, what's driving that underperformance, given that you're making a distinction between the different kinds of sustainability products?
Michiel Plakman (MP): Yeah, I think in general, ESG products in the index, especially in terms of fossil fuels, metals and mining, commodities, areas like aerospace and defense, tobacco, which clearly have been really strong year to date, in particular due to the conflict between Russia and Ukraine. Which has led to essentially an energy crisis in Europe and therefore has sent gas and oil prices up, as well as commodity prices, at least initially in the year. And so I think that explains part of the underperformance. Maybe the second factor is that most ESG strategies are also growth-oriented or growth strategies, usually with valuations or with cash flows further out in the future. And so that clearly has not helped sustainable strategies overall.
EM: For the sake of the audience, that was Michiel that just spoke, and of course, Chris before him. These market moves, as I've said, have raised some questions about the merits of sustainable and ESG investing, or at least has amplified them. John Authers is Bloomberg Senior Markets editor. He sums it up quite nicely here. Let's have a listen.
Audio fragment: Until now, you've been able to have your cake and eat it, because ESG investing has actually generally outperformed non-ESG investing. That's because the oil price has been low and there's been great excitement in having, putting money into clean energy stocks. Once you have an oil price rocketing higher, you begin to have to make some more painful decisions about whether you're really going to make, whether you're really prepared to forsake money to do ESG. So that's one major part of it. Then there is a broader sense of a reckoning with the attempt to make capitalism kinder. Now that ESG has got as big as it has, people are beginning to ask, is this working either; is this actually slanting playing fields in ways we don't want?
EM: So that's a very simplified way of summarizing the situation. But if we look at some of the concerns and criticism of this form of investing; firstly is the argument that you have to give up returns, as John says there. Do you believe that there is a trade-off between performance and sustainability, whether this is in the short term, medium term or long term?
CB: No, not necessarily. In fact, we've been through several downturns over the years, different kinds of cycles, right? And we have plenty of evidence that through the cycle and also in downturns, sustainable strategies actually had less drawdown. So it's a better protection against downside risk. Now, of course, every environment is different and the one we're in today with indeed very high energy prices, we have a war raging on the European continent, meaning that lots of companies in the aerospace and defense segments are doing really well. And of course they are on many exclusion lists, which arguably makes it much more difficult to outperform also in those kind of environments. But I have to say that there are still plenty of opportunities to flex your strategy in such a way that you're able to find opportunities elsewhere, find perhaps similar, let's say, factor exposures that also mitigate against downside risk and still, you know, provide plenty of opportunities to have good financial performance.
MP: And in the end, right, sustainability is about having a good business. As the word says, right, it's building a business or having a business model that's sustainable. So not for the next three years, but literally over the next decades. And so when you take a step back and say it's not just about alternative energy stocks or other particular examples of sort of pure sustainable strategies, sustainability really is about having a healthy corporate culture. Moving away from, let's say, shareholder capitalism to stakeholder capitalism. I think Michael Porter started that with his article on shared values. In the end, sustainability is about having a good and sustainable business model long term, which means that you take all stakeholders into account. And that's incredibly important. So, [for] one, the theme is much broader. I think what does not help is that [in] the previous years we've seen tremendous capital flow towards sustainability and towards ESG ideals, maybe to an effect that there has been, let’s say, a mini ESG bubble, and maybe that’s correcting itself. In the long term, that's only healthy, I would say.
EM: It’s clear to me in your response to my question on whether or not there is a trade-off depends on your definition of sustainable funds. And I think to an extent you've covered that. But I can't help thinking of and referring to the paper by Cliff Asness in 2017, Cliff from AQR. So from very much a quant approach, he entitled his paper “Virtue is its own reward”. He concludes his research by saying, “Frankly, it sucks that the virtuous have to accept a lower expected return to do good and perhaps sucks even more that they have to accept the sinful getting a higher [expected return]”. So, his finding is that there is indeed a trade-off. So what definition is he looking at in terms of this, Chris?
CB: Well, perhaps a very narrow definition. Indeed, to your point, it depends on the type of sustainability strategy that you run. I guess we have so many different flavors out there, whether it's truly impact-related, best-in-class, more exclusionary-based, but also lots of mainstream ESG integration strategies. So for example, the strategy that both Michiel and I and the rest of the team run really does mainstream ESG integration next to running impact strategies. So there is indeed a difference between the two. I would say that impact strategies have a more narrow universe, so there the objective is really a sustainability objective. Financial returns come second, whereas with ESG integration, it's the other way around where sustainability is more a means to an end. But it also means your strategy has more flexibility to find interesting names in both the growth end of the market, but also the value corner of the market.
EM: So, you're saying in this, Chris, and maybe Michiel, you could answer this. So it depends on the investor objectives, whether the investor is willing to sacrifice returns. So whether or not there's a trade-off depends on the asset owner.
MP: Oh, clearly. Yeah, that's extremely important, right. I mean, to give an example, we spoke to a prospect last week or actually this week, where one of the objectives that they have for their portfolio, because they're a very public organization, is that they cannot have their name in the paper associated with a particular stock or with a particular corporation that's in the news negatively. And so therefore, their objectives in terms of return, sustainability, etc., are quite different from, let's say, mainstream clients that primarily look for return and outperformance of the strategy over time. And so it really depends on sort of the objective that the client comes to us with, whether they're actually suitable for, let's say, a sustainability strategy that really integrates sustainability but is primarily aimed at driving performance or having financial returns, or whether their objective is really primarily sustainable or furthering the SDG goals, which comes before financial returns.
EM: Now at the beginning, I framed this as market developments, sort of really amplifying the criticism of this asset class. And a lot of this criticism is not so much just about people questioning this approach and questioning not having returns as the primary objective, but at the opposite end of the spectrum, criticism that it's not being done properly. And I think perhaps that misses the point that you're making that. Yes, well, it's up to the investor to choose what they want. David Blood, for instance, co-founder of Generation Investment Management, says the biggest mistake investors make is to try to boil down ESG to a checklist or an index. He says that checklist is a blunt instrument that doesn't reflect the challenges, subtleties and trade-offs of ESG. And that's in a Financial Times piece entitled “How ESG investing came to a reckoning”. And I think it's supportive of what you're saying, that it requires – as you referred to earlier, Michiel – stakeholder capitalism.
MP: Yeah, I think it's really important. It also touches on the point of not just using sustainability scores and then forming your portfolio, right. I mean, we use the scores really as a starting point, but that's where the fundamental analysis starts. And I think this is really important, is that you have to do your homework on the names that you own in the portfolio. As we call it: sustainability provides us with a different lens. So an SI analyst will look at the particular company from a very different perspective as the financial analyst will look at a particular company. But it's really helpful in identifying both risks as well as opportunities for a company, long term. What's quite important here is that the horizon may also be different. So to give an example, we typically model out the financials of a company three years, but for instance, a huge sustainability risk over time could be regulation. And so the point here is that the SI analysis adds a different lens to analyzing a company that actually can be really helpful and provides very different information from the pure financial analyst perspective, that actually helps mitigate risk and identify opportunities long term.
CB: And maybe to add to that a little bit, I think indeed most approaches have been really simplistic in terms of just following ESG ratings, ESG scores, and that's it. Very rules-based exclusion policies. But I think this current environment also helps us to further advance sustainability investing as such, right? To go beyond that, indeed, to Michiel’s point, provide much more context, fundamental analysis. Have a much more forward-looking approach, and really try to find the relevant context. And I think that's sometimes overlooked. Also, the fact that we should have much more open dialogues with the company, sit down with them, have more thoughtful engagements. That's something that is often missed out or, yeah, difficult to quantify. To boil it down into one particular score. And that is ultimately not what sustainability investing is about.
EM: Chris Are you also saying then that market environments such as this is forcing innovation in the field of sustainable investing? You know, you've had a rising tide that lifts all boats and now the tide is pulling back and you're seeing where the cracks are on the system and who's really doing this properly.
CB: Sure. Of course. Yeah. I mean, the simple exclusions, for example, on the energy side by basically divesting everything related to fossil. To a certain extent, that makes sense. But at the same time, there is a competing priority with the social component there. In other words, higher energy bills for many consumers out there. How to deal with that. Of course, that got aggravated by the conflict in Ukraine. But clearly, the energy side of things has been competing with climate change objectives. And by going too black or white on the whole energy sector, which is basically the bedrock of modern society, we've seen too many simplistic rule-based kind of exclusions in that field. And I think going forward, we have to go much smarter about that as well to further advance it.
EM: And also the risk of overpaying, I think Michiel, was it you who made the point earlier, that these typically have been growth-type stocks, the ones innovating perhaps in the field of energy and so on. So is this another lesson being learned, not overpaying for stocks that are good or at least considered to be doing good?
MP: Well I think in general, right, there's two things. One is that particular ESG darlings have received a huge premium. And that, of course, has been difficult, especially in an environment where interest rates have been rising and multiples in general have been coming down. A second is that a number of the companies that provide long-term solutions also have their cash flows out further in the future. And so they're really long-duration stocks that also in an environment where interest rates are rising, potentially have corrected. The thing is, though, that it's important to keep your eyes on the prize. There will be, and increasingly so, more capital available to fund those ideas. It also shows that it's just incredibly necessary. Just look at the energy crisis that we're currently having in Europe. And so also from an energy independence perspective, it's really important to think about those potential alternatives. And so therefore, there really is a long-term future for those names. But clearly, as an investor, you should always look at, okay, well, what do I pay for a particular name at my entry point? And really, what's my horizon in owning this particular name?
CB: Indeed, I think valuation discipline is always important with any investment strategy. And I think it's, of course, not only whether you run an impact or more mainstream ESG strategy that you try to shop into the growth corner of the market. But in the value segments, you have plenty of opportunities. Now, the approach that we take is to focus more on quality companies. And the beauty of that is that you can find very interesting opportunities both on the growth but also on the value side of things. And especially on the value end of the market, you tend to find more the improvers on sustainability. So through active engagement, for example, you try to sit down with management to see, hey, what kind of strategy do you have in terms of sustainability? How can you further improve that in order to enhance your value-creation capability? So it's really that mix that you're trying to find and also find that diversification in your portfolio.
EM: You're in the thick of it, thinking about sustainable investing all day long, thinking about valuations, finding quality stocks, etc. But if we just take a sort of a higher-level approach, it's quite evident, in the past six months or so, this discussion around ESG-type investing and the criticism around it, particularly in the US market, I see. And it's become quite politicized, a vocal pushback on ESG-type investments. And it could be because of this that some of the major global asset managers are reported to have backpedaled on some of their voting commitments at shareholder meetings. See, for example, the recent FT piece entitled “BlackRock pulls back support for climate and social resolutions”. What's your view on these developments, that there's this political response that could again feed back into how you invest?
MP: Yeah, I think for us it's less relevant. I think as a relatively small and nimble organization, really focused on sustainability, I think we can stay away from the political debate. I mean, what's really quite interesting, is that if you look at our voting behavior, and that's done mostly in cooperation with our active ownership department, we tend to vote in favor of shareholder proposals that support either environmental, social or governance proposals let's say 90% of the time; we actually got an update on the voting year to date yesterday. So the advantage of an organization like Robeco is that you don't really have to care about what's happening politically. Obviously, we're less sensitive to the political debate in the US and one of the things that I think is important to keep in mind as well is that to some extent how you look at sustainability is also very culturally dependent. So for instance, when you speak to a client in Southeast Asia, they may actually care about lots of different points than actually a European or even a Scandinavian or a Dutch investor may. The same may be true in the US. The thing is, right, the whole sort of philosophy that we work with is that adhering to good sustainability standards is actually really good business practice and therefore that it will pay off in the long run. So we like to stay away from sort of the political debate and think that, in the end, this is just the right way to go about business, also from an investing perspective.
EM: But Chris, that sounds tricky: factoring in cultural differences on what sustainability means, factoring in different asset owners’ views on what they want, and also the time horizon that you mentioned. How do you go about this?
CM: Well, I think in the end, you need to have a good, diverse mix in terms of your allocation towards the ‘E’, ‘S’ and ‘G’, let's say, within the portfolio itself. Maybe to one of the earlier points we discussed on fund flows, on underperformance, I think that has to do mainly with the fact that sustainability investing has been associated with the ‘E’, so more on environmental themes. So I think that having more exposure also to the social dimension, corporate governance blended in there really works well. I mean, looking at our own investment strategies, the last few years, we had okay performance from some companies that are more associated with the social dimension. Well, that during Covid, the pandemic, we really saw most of those companies suddenly surfacing and becoming more important as part of the investment strategy. And I think overall, it's really to have the right balance there and not just narrowly focus on one particular element of sustainability investing.
EM: Michiel, Chris has touched on this, but if we were to start drawing this to a close, what does all of this mean in practice from a portfolio construction and a stock selection perspective? And I even would want to challenge you in terms of what does it mean; what should asset managers be offering to clients in order to make sure that we're moving ahead on sustainable investing?
MP: I think for us the importance is that we've always focused on quality. Increasingly, I think sustainability is a quality trait, and that you see that companies that actually focus on sustainability really in every aspect actually are the higher-quality companies. And so that's what we continue to be focused on. And so from a portfolio-construction perspective, we like to say that the portfolio really is a competition for capital. We're always looking to improve the portfolio on every metric that we look at. And so we're really focused on return on invested capital, free cash flow and sustainability profile. And so we'll continue to do so, right? The strategy really is a quality strategy and sustainability is an important element of that quality framework.
EM: So, where does all of this leave us in terms of a commitment – philosophically, but also in practice – a commitment to sustainable investing? Will there be a decline in the appetite for sustainable investing strategies and products? Or, on the other hand, is what we're seeing now in markets, will asset owners demand that sustainable investing be done far better than it is, generally speaking?
CB: I think to your first point, have we seen sort of the end of the ESG fund flows? Definitely not. If you look at the total assets under management, globally, sustainable investment strategies are not even 10% of that. Of course, we've seen fund flows coming down in recent quarters, but actually the last two months we saw an improvement and a tick up. And in fact, looking at the broader fund flow base, we've seen much more flows going back into the more sustainable strategies rather than the non-ESG funds, let's say. I think next to societal tailwinds, regulatory tailwinds are also very strong across the board, in North America as well; whether it's the recent Inflation Reduction Act or SEC rulings on sustainability disclosures. Here in Europe, we have the EU taxonomy, Sustainable Financial Disclosure Regulation; in the Asia-Pacific region also plenty of new frameworks that probably support further fund flows and try to really redirect and accelerate investments into sustainability strategies.
MP: And I think an important element is: do what your clients ask you to do or what requirements from clients are. I think one of the things that has happened too little in our industry is actually having a really good conversation with your client about what are you ultimately trying to achieve? What is most important to you? And so I think there, sustainability is really important as well, that you have a conversation with your client or with your prospect on ultimately what are the key objectives, what's most important to you; what do you care about most; and how can we facilitate that request. And one of the things I'd like to ask when we speak to a client or when we speak to a prospect, is when is our relationship a success? Because so far it's really been about product and selling something to a client, maybe without having that precise discussion. I think in terms of sustainability, that's really important. Understanding the needs of a particular client, also in terms of sustainability, so probably not just have a discussion on what are your return requirements, what kind of outperformance are you looking for? But also in terms of what are really your sustainability or your social objectives that you'd like to see fulfilled with this product?
EM: And do you find in this discussion that there's mutual feedback and mutual growth because that discussion certainly must clarify objectives?
MP: Well, one of the things that's really surprised me most is that different clients have very different needs where you could simply say, well, in the end, all clients want is outperformance. That has not turned out to be true. So, different clients have very different objectives or are very particular about what they'd like to achieve with their product. And what's important for us as a service provider is really having that conversation and making sure that we meet the objectives that clients set, in particular when they come to Robeco, because they do want to have a sustainable solution.
EM: Michiel Plakman, Chris Berkouwer, thank you so much for your time and your insights. It's been so good talking to you.
MP: Thank you, Erika.
EM: And to listeners, thanks for being part of our conversation. We'd love to hear from you. Please do send us your comments, your feedback and suggestions to email@example.com. And you'll find all of our podcasts on your favorite podcast platform as well as at Robeco.com.
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