“There are three things lurking behind that desire to invest in a sustainable investment fund,” Julian Kölbel, professor of sustainable finance at the University of St. Gallen, told attendees of the Sustainable Investing Forum held earlier this month.
Kölbel thinks that it is not sufficient to only ask clients whether they want to invest sustainably. In his opinion, an advisor should review the following three motivations to assess the proper products against the investor expectations.
First motivation: financial performance
Kölbel explained that investors “may have that conviction that by taking into consideration extra financial information,” such as climate risks, they “may suddenly have an improved investment performance […] in the long run.”
Second motivation: values alignment
Investors may want to achieve a certain level of standards when it comes to their personal values. Kölbel suggested that despite the financial upside potential in investing in tobacco or coal, some investors are saying: “I just don't want to be involved [in these industries as] I believe it is ethically wrong.”
Third motivation: impact
Kölbel suggested that impact is the opposite of values alignment as investors are saying: ”I want to be very much involved.” He thinks that these investors want to change outcomes and that they are interested in the consequences. As cancer is one the consequences of smoking, these investors are asking what they can do to reduce the risk of lung cancer.
Kölbel reported that German and French retail investors said in a survey in 2020, that their primary motivation is to fight climate change and to have an impact (46% of respondents). The second priority was financial performance (36% of respondents). However, he admitted that it is unclear how much money is put behind those priorities.
Impact is not a rational concept
On the other hand, it appears that investors are not ready to pay significantly higher fees to be impactful even in cases where the fund being offered would reduce carbon dioxide emission by 90%, according to a survey run by Kölbel and his colleagues. He concluded that “investors are willing to pay for impact, but the amount they're willing to pay is really based on an emotional evaluation.”
ESG funds tended to sell the companies that have been downgraded over a relatively long timeframe [24 months].
As investors “don’t discriminate between some sort of product with a little bit of impact and one with a lot of impact,” Kölbel stressed the importance of labelling funds “that do a good job of discriminating [between funds].” He considers a targeted labelling as a very influential factor for investment decisions.
Labelling, ratings and performance are driving fund flows
Kölbel underlined the challenge of “evaluability” for professional and retail investors alike. As it is very difficult to assess whether a sustainable financial product is green, a by professors in Chicago observed that investors have shown that they respond “very strongly” to the “obvious labels” as “they don’t bother going into the details. It’s very natural,” said Kölbel.
These researchers, noted Kölbel, observed that from 2016, when Morningstar launched its sustainability rating methodology (one to five globes), the five “globes” funds enjoyed inflows whereas the funds achieving only one “globe” suffered outflows.
In a different in which Kölbel also participated, he looked at the change of holdings in the ESG funds after rating transitions were operated on companies by MSCI, the index and rating firm. They noted that “ESG funds tended to sell the companies that have been downgraded over a relatively long timeframe [24 months] [and] same thing on the other side with upward rating [transitions].” It demonstrates that ESG funds are not “regular funds in disguise,” as they “respond to relevant information.”
Moreover, Kölbel contributed to a which shows that a rating downgrade resulted into an abnormal return of minus 3% over 18 months. On the other hand, a rating upgrade did not result in conclusive positive outcomes as “the uncertainty bounds are wider” or said differently, the range of outcomes is wider than for a downgrade.
But then what?
The stock performance is public information. What is going on behind the scenes, during company board meetings? Kölbel thinks that downgrades lead to changes at companies. However, the change of ratings does not normally lead to immediate changes. “We know that things are evolving.”
This article was published for the Delano Finance newsletter, the weekly source for financial news in Luxembourg. .