An academic report from the University of Edinburgh published in September 2015 suggested that European green funds significantly outperformed their fossil-fuel counterparts or “black funds” over the 2012-2014 period, whereas they used to significantly underperformed conventional funds over the full 1991-2014 investment window. Once poorly considered by risk-adjusted return seeking investors, green and ethical funds are becoming more and more “trendy”. Here are some key insights to understand why and how to apprehend this trend.

Sustainability is business

To echo the opinion of many green investors, companies that engage into sustainable and environmental-friendly practices are likely to experience better financial performance than their peers not despite  their focus on sustainability but precisely because of it. As a matter of fact, sustainability is becoming crucial to most businesses in the world. To cite some examples, companies such as HSBC or Volkswagen have been severely sanctioned by the market once elements of unethical behavior came to light, such as the financing of Mexican drug cartels from the part of HSBC or the use of cheating software systems to deceive carbon emission controls from the part of Volkswagen. Companies that do not live up to high sustainability standard regarding their environmental footprint or their level of ethics face the risk of incurring high sanctions, not only from regulators but also from their own investors and the market. On the other hand, sustainable firms are the ones which are the most likely to achieve growth in the long term.

The multiple ramifications of the word “green”

8636108919_66e5e6ded7_oSo-called green, sustainable or ethical funds are funds that invest exclusively in companies which, according to their standards, have implemented sustainable policies in their business model. Nevertheless, selection criteria can be extremely diverse. For instance, a fund might decide to invest exclusively in companies which have, as clear mission statement, to make the world a better place whereas other funds might decide to invest in “black” companies which have made the commitment to alleviate their impact on the environment. A fund might consider animal rights such as animal testing as a criterion for its portfolio allocation whereas another fund might rather put the focus on organic and fairtrade products. Each investor has thus to be very careful about which fund he or she would like to pick according to his or her own preferences.

Drivers of the performance of green funds

Many changes in the regulatory and business environment in the developed and developing world have made green funds more attractive over time. As we said earlier though, there are as many green funds as one could possibly imagine. However, some general considerations can be made. First of all, as mentioned by Eyraud et al (2013), regulations have been particularly favorable to green energy companies during the last couple of years, especially in the EU. Government subsidies and the implementation of carbon pricing schemes (i.e. a system in which low-polluting firms are entitled to sell carbon rights to high-polluting firms) have provided a competitive advantage to green energy companies and, to a broader extent, to companies that rely on “clean” energy, in comparison to their peers. Secondly, the currently low interest rates environment has made cost of capital relatively low, pushing firms to invest in new projects, among which green projects. Thirdly, the increasing energy demand, combined with the high volatility of fossil fuel price, has made investment in green energy comparatively less risky and more profitable than it used to be in the past.

Last but not least, consumer awareness of human and animal rights has dramatically increased for the last five or ten years and health issues or citizens questions about corporate supply chains are becoming central in public debates nowadays. Furthermore, thanks to the widespread use of social media such as Facebook or Twitter, corporate scandals are now easily and quickly spread which has increased the business risk of engaging in unethical activities for firms. Many companies are now aware of these trends that represent both a threat and an opportunity for their activity. Put shortly, there is a real consumer demand in the developed world for more ethical, sustainable and socially responsible firms.

Why one should still think twice before investing in green funds

6955492331_041014853d_oThis being said, many criticisms can be made towards green funds. First of all, as we said earlier, it is not always straightforward to grasp the portfolio allocation philosophy of these funds. An investor might thus be deceived if he or she does not pay enough attention to the selection criteria of the fund he or she is investing in. Secondly, from a genuine risk-adjusted return viewpoint, one can argue that investing exclusively in ethical or sustainable firms reduce the investable universe considerably (sometimes by more than 80%!), which gives less room for diversification. Moreover, it has been shown that such funds usually display a strong bias towards small stocks and growth stocks, which are known to be more volatile.

Finally, there are significant differences in historical performance between such funds. For example, the FP WHEB Sustainability fund, a multi-thematic fund that invests exclusively in companies that, according to their view, provide solutions to sustainability challenges, has outperformed the MSCI World benchmark by more than 7% on a 3-year cumulative performance basis from 2012 to 2015 but it also has underperformed its benchmark by more than 15% on a 5-year cumulative performance basis from 2010 to 2015. The Aberdeen Ethical World Equity fund, a fund that invests in companies on the basis of ethical and socially responsible criteria has massively underperformed the FTSE World benchmark on a 3-year and 5-year cumulative performance basis.

Despite these criticisms, it appears undeniable today that so-called green and ethical firms are occupying a growing share of the investment landscape, attracting not only ethically driven investors but also classical investors seeking risk-adjusted return. Sustainability is crucial for most companies in order to grow in the long run. In the same time, the business risk of engaging into non-sustainable activities can be very high as suggested by the Volkswagen scandal. Whether green funds are likely to outperform black funds in the future does not look as a very unreasonable forecast but whether green funds are likely to outperform all conventional funds in the near future remains still unclear.

Cover picture courtesy CDC Global

Photo by Olivier Girard for Center for International Forestry Research (CIFOR)

Picture courtesy: British Province of Carmelites