Can you have your cake and eat it?

By: Willem Schramade – Head of Sustainability Client Advisory at Schroders

“There is no such thing as a free lunch”, and “you cannot have your cake and eat it.” Indeed, many languages have such expressions that say that where there are benefits, there tend to be costs as well. This kind of scepticism is applied to sustainable investing as well. The perennial client question is: does sustainable investing cost returns?

The short answer is no. Academic evidence (see for example the meta-studies by Friede et al. [2015] and Atz et al. [2022]) shows that sustainable investing typically does not cost financial returns. But that doesn’t take away client concerns. And the more nuanced answer is: it depends. Yes, sustainable investment approaches can enhance risk-return profiles, by means of better risk management, better fundamental analysis, and/or more favourable factor exposures. But they can also hurt risk-return profiles due to excessive investment universe reductions. It very much depends on the goals and methods used.

There is much talk about sustainable investing methods (exclusions, ESG integrated fundamental analysis etc.) and the data used, and indeed there is much to be discussed there. But it would be a shame to skip the goals. As the Roman philosopher and statesman Lucius Seneca is quoted as saying: “If one does not know to which port one is sailing, no wind is favourable.” In sustainable investing too, you need to know where you’re going to actually get there.

There are typically two types of goals in sustainable investing, which both come in various degrees, from non-existent to very ambitious, and which can be combined to varying degrees:

Sustainability as a means for achieving financial results (this is what most ESG integration is about); and

Sustainability as a goal in itself: achieving better social and environmental outcomes, where clients may set very specific desired outcomes.

And increasingly, institutional investors want to be ambitious in both. The relation between these two goals is not straightforward: in some cases they reinforce each other, in other cases they involve trade-offs.

Let’s start with the first goal. In its most superficial shape, this entails simply wanting to keep stakeholders and regulators happy – and avoiding reputational damage. More ambitious is to aim for better risk management. In its most ambitious shape, the goal is achieving a better understanding and management of risk, opportunities, and returns, in a way that combines data and fundamental forward-looking analysis. This can indeed strongly improve risk-return profiles.

The second dimension, sustainability as a goal in itself, also comes with varying ambition levels. Here the spectrum starts with having no such goals whatsoever, but most have moved to the next stage: the goal to avoid the most serious harm, for example by excluding, say, the violators of the UN Global Compact, the world’s largest voluntary corporate sustainability initiative. But investors can choose to be stricter on their exclusions. In addition, they might want to select their investments for doing good, formulating positive selection criteria. This can be done in at least two ways.

The obvious way is to make investments that demonstrably make a positive impact: Article 9 eligible under the EU’s Sustainable Financial Disclosure Regulation – sustainable investment is the core objective. The less straightforward way is to invest in companies that have a negative contribution to social or environmental value, but with the commitment to strongly improve their contribution through active engagement. The latter would not fit Article 9, but could fit the UK Financial Conduct Authority’s proposed Sustainable Improvers category (recognising that we are yet to see the final text of that regulation). And, back to the returns question, there is evidence of alpha generation from such strategies, both in proprietary and academic research (see for example Dimson et al., 2015).

While there can be positive alpha in Article 9 propositions as well, depending how they are designed, such products can also involve giving up returns or at least assuming more risk: think of ethical investment funds that are so strict in their investment criteria that their universe is excessively reduced; or impact private equity products that have single digit internal rates of return (IRRs) at double digit IRR risk levels because they share the returns with the local population. That may be great for society, but is not within a pension fund’s mandate. Still, it might be a good proposition for some retail or high net worth individual (HNWI) investors who are willing to give up returns for (a lot) more impact.

The challenge is to understand where you (and your clients) are on these two dimensions of goals. The above mentioned pension funds are ambitious on both goals: they want to achieve positive social and environmental outcomes, for example aiming for net zero, without giving up financial returns.

Once the goals are clear, the other questions can be addressed: how to operationalise the goals? How to define success? What strategies to use? What trade-offs are involved? How to measure? With what data? How to communicate to constituents? How to explain to them that you are indeed not giving up returns, even if it looks like it?

A director of a Canadian pension fund put it roughly this way: “We don’t give up returns in sustainable investing as it would not be within a pension fund’s mandate to give up returns. The horizon is crucial: our mandate is to generate good returns over the next 50 years. That means we need to invest in future fit business models. Sometimes we seem to be giving up returns when in fact we are mitigating long-term risks at the expense of short-term returns. In fact, negative externalities represent short positions in companies, which is often not recognised, so the risk is underestimated.”

The perceived trade-off between sustainably-run companies and the returns they deliver is misplaced.

It is indeed hard to see how returns can be generated without considering sustainability against a backdrop of those sustainability challenges creating risks, opportunities and political and social interventions.

This highlights the importance of Schroders’ models on externalities. They are part of our effort to understand the risk-return implications of sustainable investing, especially where the data is fuzzy – while still applying a solid portfolio construction process.

That is not a trivial pursuit. In that sense there is indeed no free lunch.