Does responsible investing come at the cost of returns?

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“In November 2020 we had news of successful vaccine trials, which led to the expectation of economic growth and inflation. This led to those areas that were particularly hard hit during March to April 2020 such as financials, oil and gas companies and airlines outperforming the market, and those sectors that had previously held up well underperforming.

“In terms of fund performance, this led to a reversal of what happened in March, with agnostic strategies and particularly those focused on value outperforming approaches focused on responsible investment. This trend has largely continued in 2021.”

Rob Morgan, chief analyst at Charles Stanley, says “stringent” ethical or sustainability exclusions may at times have a detrimental impact on performance, especially over shorter time periods.

“Any process that drastically reduces the number of available investments, for instance by screening out whole sectors and industries, does reduce the opportunity set, and this might lead to periods of underperformance or outperformance against a standard benchmark due to the portfolio biases it creates.

“For instance, excluding the energy, mining and tobacco sectors from a portfolio on responsible or ethical grounds could reduce diversification. These are important constituents of many indices, the UK’s FTSE 100 being a prime example, and if they perform particularly well or badly over a given period then there are consequences for the relative performance of socially responsible funds that do not hold them. 

“Broader forms of responsible investing prioritise engagement over exclusion or divestment, though, which can mean a more diverse and well-rounded portfolio that still aims to raise environmental or social standards across companies and industries.”

But Morgan also says that companies managing ESG risks are more likely to avoid major pitfalls or controversies.

“Those that are improving could boost their value in the eyes of shareholders as they come to be perceived as higher quality,” he adds. “Any investor assessing a business should find that considering these risks is helpful and potentially beneficial to long-term returns.”

Chloe Cheung is a features writer at FTAdviser