While many investors focus on the returns of ESG portfolios, others are looking at businesses that will need to adapt their business model to be more ESG-positive but are yet to do so. So how do you get on top of the wave that is momentum investing?
Human-induced climate change is causing dangerous and widespread disruption in nature and affecting the lives of billions of people around the world, despite efforts to reduce the risks. Our actions today will shape how people adapt and nature responds to increasing climate risks.
This is the view from the latest Intergovernmental Panel on Climate Change (IPCC) report, released in February. It makes for grim reading, and suggests that efforts to mitigate climate change – much of which were promised as recently as November 2021 at the COP26 Summit in Glasgow – are inadequate.
The role of the financial sector will be critical to propelling capital towards projects that manage environmental risk to prevent global temperatures increasing by more than 1.5ºC.
Policymakers are placing increasing emphasis on environmental, social and governance (ESG) investment strategies as part of the solution, resulting in considerable growth in global sustainable fund assets.
According to recent research from Morningstar, investors poured $142bn into ESG funds in the fourth quarter of last year, representing a 12% increase on the third quarter to reach $2.74tn in assets at the end of December 2021.
Yet not all investors are rewarded with outperformance from ESG funds. Morningstar also reports that, across all asset classes, 49% (70 of 144) of sustainable funds outperformed their respective category averages.
This was led largely by equity funds, among which 59% (52 of 88) outperformed their peers.
It is incumbent on asset managers to find more effective ways of gaining returns from sustainable investment.
And according to Mark Cleary, Director at Zedra, this means moving away from investing in stocks with demonstrable ESG credentials in favour of those that are on the cusp of a transition to more responsible practices.
Momentum strategy
“A good investment is not necessarily the same as good future profits; it very much depends on the entry point,” explains Cleary. “Often with mainstream ESG strategies, the portfolio is tilted towards the ESG leading [stocks] that already have good credentials. So arguably, their prices bid up already.”
An alternative to this ‘best in class’ approach is an ESG momentum strategy, which chooses stocks based on their ability to gain value by improving their sustainable credentials.
Cleary says: “If you can identify suitable assets at an early stage – before they really get on their ESG journey, ahead of being priced up – then in theory you can benefit from the future performance of the company, as well as investing in assets with wider benefits to society and the environment.”
At last year’s COP26 summit, the Chancellor, Rishi Sunak, said that all UK financial institutions and public listed companies would be obliged to publish plans detailing how they would be reducing the emissions they respectively finance or for which they are responsible.
This should make it easier for advocates of ESG momentum investing to identify stocks with the potential to deliver value in future.
Identifying opportunity
However, in a world awash with ESG ratings agencies and sustainability data that is not always verifiable. Identifying a company that’s genuinely on the up in sustainability terms is not always easy.
Oliver Crowley, Investment Funds Partner at law firm Pinsent Masons, comments: “As the UK government has noted, there is not yet a commonly agreed standard for what a good-quality transition plan looks like.
“In all likelihood, however, as with the EU’s regulation on sustainability-related disclosures in the financial services sector previously, they will be expected to comply in some form before the guidance and the agreed standard settle. It is also unclear what consequences, if any, there will be for non-compliance with the transition plan requirements.”
In the absence of agreed sustainability standards and with the muddle of ESG data available in the market, momentum investors are beholden to their managers’ analysis, research and stock-picking skills.
According to Stephen Metcalf, Head of Sustainable Investing for RBC Wealth Management in the British Isles and Asia, momentum investors look at “similar metrics to those in traditional ESG strategies”.
“These might be improving stock-specific factors such as governance remuneration, diversity, inclusion and, on the environmental side, how the company is managing its resources and what its carbon footprint is like.”
But rather than looking at a company’s current ESG score, investors weigh up the likelihood of that score improving in the future as a result of changes to policy and processes.
Metcalf points to the industrials sector as a good source of potential momentum stocks, noting that many of these companies will be forced to adapt their processes to be more sustainable.
“In the future, in a net-zero, low-carbon world, we still need to produce all these commodities. If you think about steel, for example, the questions for momentum investors are: which company can produce steel most sustainably; and how can we make production less energy-intensive?” Metcalf says.
“It’s important that you think about how they’re sustainable. We aren’t necessarily looking to change the business model completely, but find ways companies can operate more sustainably.”
Recruitment tactics
Other clues indicating that a company is about to embark on a more concerted sustainable journey lie in the people it hires.
Damien Fitzgerald, Head of Funds Guernsey at Zedra, highlights Guernsey Gas’s recent appointment of Alex Herschel as Managing Director from Guernsey Electricity, where she was Environmental Sustainability Manager.
“It’s not just a company’s ESG policy that matters, it’s the individuals they are hiring as well. It is important to look for companies that demonstrate there is an ESG ethos and culture that runs from the board right to the shopfloor.”
Given the emphasis on the future, rather than the now, for momentum strategies, a successful stock theoretically could be found in some of the sectors with the current highest carbon emissions and the worst employee rights records.
Metcalf says: “There are companies that are completely changing their business model to go from dirty industry to clean industry. For example, a coal company that is looking at wind power or renewable energy would obviously be attractive.”
In terms of accessing ESG momentum strategies, Metcalf says the current market cycle – which favours value (momentum) over growth (best in class) strategies – could lead to more fund launches.
“In a world where energy – which is material to a lot of ESG portfolios – is performing well and high-quality growth stocks are being hurt by rate rises, ESG investments have to look for other ways of diversifying.
“Momentum investing is one way to do that. I expect to see more asset managers launch momentum products and to expand the universe for investment.”
Capitalising on ESG momentum
In 2019, Harvard Law School produced research to demonstrate the efficacy of ESG momentum-based strategies.
In 2013, researchers built a model ESG portfolio, which they regularly rebalanced based on data from ESG ratings provider Sustainalytics.
From March 2013 to January 2019, an investor who bought the top 30% ESG-rated companies would have outperformed the STOXX 600 index by more than 9%.
However, if they had bought companies with a positive ESG momentum – those that improved on their ESG rating by more than 10% year on year – they would have outperformed those same 600 European stocks by 23.5%.
The researchers also found that the average outperformance of companies with improving ESG ratings versus the STOXX 600 was more than 3% in each of those years, with a cumulative outperformance of more than 20%.
The Harvard research concluded: “We have found that within the top ESG-rating portfolio of approximately 150 stocks, those names that showed an annual positive change in ESG rating of more than 10% did perform better than those with either neutral or negative momentum over our performance period.”