Introduction: Continued, But Uneven Growth
Sustainable investment funds(1) have been available to US retail and institutional investors for a number of years. Earlier versions principally relied upon exclusionary screening processes. This is changing as fund managers are placing more emphasis on sophisticated and multi-layered ESG-integration approaches. Overall, the number and types of sustainable funds on the US market, their AUM, and the range of investment management companies offering these products have grown. U.S. investor awareness of sustainable funds and investments has also grown.
A level of comfort can be taken from these developments. The strength of fund investor and industry interests in sustainable investing is encouraging, but the unevenness of some of these developments should not be ignored. They have brought with them new opportunities, but also unprecedented challenges for the fund industry. In this paper we identify a number of these challenges, especially those that may be new to the industry. Further, we explore the developments and the factors that may affect the future of the sustainable fund marketplace.
Demand & Supply Considerations
Investor Demand
Awareness of sustainable investment funds and strategies among institutional investors, including plan sponsors, is well established. We believe that one of the main impedances are fiduciary-related and the possibility of heightened regulatory restrictions. Not only do questions persist as to whether financial and non-financial considerations can be identified as part of a fund’s mandate, but more fundamentally, managers and investors alike are asking what actually constitutes sustainability and ESG-factors? The lack of standardization contributes to investor’s uncertainty as to what they are actually investing toward. This “invites” greenwashing by some companies – a potential credibility issue for the industry overall.
For retail investors, awareness, interests and general acceptance varies by demographics. For example, millennials and female investors are keenly interested in sustainable investing. Older investors who may be more financially established, while interested, are generally less so than millennials. Moreover, a general lack of pro-activeness on the part of financial intermediaries toward introducing sustainable funds to their clients is a hurdle towards making in-roads among retail investors. This is especially true for some financial intermediaries is with long established “client-bases” of older investors.
Sustainable Fund Product Supply
As noted, the range of sustainable fund products in the U.S. has steadily expanded, as has the number of asset managers entering the market. There is though, a concentration of offerings from larger domestic managers. This applies to both actively and passively managed sustainable offerings. However, more specialized sustainable approaches such as “stand-alone” impact and thematic managed funds are often favored by smaller shops.
Differences in domestically offered sustainable funds have grown more refined as well. This diversification has expanded to reflect: a broader range of asset classes and investment styles; pricing; and portfolio management approaches.
There has been an upsurge in fund rebranding or repurposing as a means for some companies, to quickly enter the sustainable fund marketplace. Often this involves managers applying an ESG integration approach to industries, sectors or companies. This may be employed exclusively or in combination with one or more sustainable strategies, such as negative screening and/or engagement.
More Than a Fad or a Market Niche?
The question many have asked is whether sustainable funds are just an investment fad, market niche product, or something more? Several factors suggest that it is likely more, including the: 1) number of new sustainable fund product launches, especially those investing in diverse asset classes, 2) continued growth in assets for these funds, and 3) broadening range of management company entrants and participants in the sustainable fund space. The true test, however, will be the staying-power of sustainable funds over the longer-term. If they exhibit the ability to weather varying market cycles, it would be safe to at least, classify them as an established investment fund specialty.
A sub-group of sustainable funds that has a long-term track record are values-based products. These funds, which we believe will retain their sector-like status in the marketplace, have their origins in values-based religious affiliations, moral, socially responsible as well as ethical leanings. Recently more “non-traditionally” targeted values-based objectives such healthy living, dietary trends, animal rights, sustainable cities, and those meeting UN Sustainable Development Goals have become a notable addition to the sector. These sustainable sector-like fund products are expected to grow in number and diversity.
We believe, however, that sustainable funds overall will eventually be defined first and foremost by their investment processes, much as portfolios now carry investment style mandates. The distinguishing feature among sustainable funds is expected to be their level of sustainability factor coverage and related refinements in their investment management approaches. These will define the determinants of a manager’s investment selections; the range of ESG factors and their weightings. Measurements of the risks associated with ESG factors are expected to become central and ubiquitous to the investment processes used by most if not all sustainable funds. As a result, the segmentation of the marketplace for such funds is expected to increasingly become a function of how comprehensive and sensitive a manager’s process is to evolving sustainability factors and their implications.
Factors Defining the Future Sustainable Fund Market “Landscape”
As the market for sustainable funds evolves to be defined more by variations in manager’s investment processes and coverage, what are some of the distinguishing characteristics that may come to define this landscape? We think that there are four highly interrelated possibilities. These include the following:
Specialized Investment Processes and Data Used to Integrate Sustainability Considerations
Fund managers utilizing sustainability and ESG-integration processes have been known to distinguish themselves by sometimes applying more detailed analytical steps and techniques. These may employ investment screens that incorporate company sustainability quality scores and ratings. Third-party ratings services have been instrumental in providing these data. Increasingly fund managers are building their own sustainability measures and ratings using in-house data and research capabilities.
Proprietary sustainability scoring is sometimes driven by the analytical needs of individual funds with specialized investments and asset class mandates, and their unique data requirements. Recently, we have seen that such in-house capabilities are being established to support sustainable management initiatives across all of a manager company’s strategies as well as, in support of broader corporate-wide sustainability business mission(s). This formalizes a firm’s and all of its fund management processes with respect to sustainability considerations, whether they be financial or non-financial. It also establishes a basis for advancing a comprehensive market differentiation strategy.
Coverage of Sustainability Factors
The range and depth of sustainability factors analyzed by a manager’s integration process is another way to distinguish themselves in the marketplace. From an analytical standpoint, the taxonomy of sustainability factors is highly diverse. As important is the “within group” variations and dynamics of these factors. In other words, what may be a highly charged sustainability concern today, may not be so tomorrow. For fund managers, the question becomes not only what factors and related weights should be used to segment the marketplace, but how to adjust this segmentation given their continually changing importance?
At another level, variations among sustainable fund management processes provide opportunities, but also complications when differentiating the marketplace. A segment especially affected by this are managers utilizing sustainable-integration approaches that adapt elements of impact engagement and proxy voting practices. In these cases, the question of sustainability-factor coverage and weighting comes into play.
Sustainable “Self-Regulatory” Standards & Market Identity
When a manager employs different sustainability-factor coverage and weightings, they are implicitly establishing self-regulatory standards. In doing so, they are distinguishing their sustainability approach from other managers.
For better or worse, a manager’s self-regulatory standards whether explicitly stated or implicated to their sustainability-factor coverage, exposes them to possible critical comparisons with competitors and broader industry practices – if industry sustainability standards are in place, it’s “safe”, but not necessarily ideal to be more stringent. This exposure can work both ways, but it can be controlled by doing one-better than one’s peers. Unfortunately, as noted, sustainability factors and their weights are dynamic. This means that being continuously aware of changing sustainability considerations will be an advantage with respect to making both portfolio management process adjustments and positioning fund products in the marketplace.
Fund Manager’s Sensitivity to Political and Sustainable “Justice” Considerations
Sustainable asset management, even when strictly adhering to financial performance and risk considerations, brings with it some “not so neat” realities. Political questions and those related to environmental/social justice are among these. At some point as the market for sustainable funds develops further, the political, and environmental and social justice stance of individual fund managers can be expected to become a point of discussion, and possibly a means of market segmentation.
Identifying sustainable fund managers and their parent companies by their political and justice-related positions should be anticipated. Consequently, the public’s perceived positioning of a fund company with respect to such issues may not be consistent with a fund manager’s design or intent. And as noted, it may have nothing to do with a fund manager’s record in meeting its fiduciary responsibilities. This means that fund managers in this space, either now or in the future, might consider their overall positioning with respect to the political and justice-related consequences of their investment decisions. Will they want to go so far as to define their market position given such issues? Probably not yet, but eventually sustainable fund managers may have little choice in the matter.
[1] While the definition of sustainable investing continues to evolve, today it refers to a range of five overarching investment approaches or strategies; values-based, negative screen or exclusionary, thematic and impact, ESG integration, and shareholder/bondholder engagement and proxy voting.
