‘It is cyclical but, over the long term, sustainable investing and corporate engagement improve investment returns say the CEOs of Robeco and Federated Hermes’. (Citywire, June 2024)
The biggest hurdles for sustainable and responsible investing continue to be a lack of understanding around the subject, coupled with an over focus on the short term
Short-termism, the fixation on short-term results at the expense of long-term objectives, poses several barriers to sustainable investing for a number of reasons.
Firstly, it causes a misalignment of investment horizons, where immediate gains are prioritised over long-term value. Sustainable investments often involve strategies that yield returns over a longer horizon, whereas short-termism prioritises immediate financial gains. This conflicts with the nature of sustainable investments, which may take years, or even decades, to achieve their full potential.
Traditional financial reporting concentrates heavily on short-term financial metrics, such as quarterly earnings and stock price movements, whereas sustainable investments require consideration of long-term non-financial metrics, such as environmental impact, social responsibility, and governance practices, which are often underreported. Funds are often judged on their ability to outperform benchmarks over short time periods. This can lead to an emphasis on short-term performance at the expense of sustainable investment strategies that may not immediately outperform, but provide superior long-term returns.
Sustainable investing often exhibits a tilt towards small and mid-cap growth stocks. This inclination towards smaller, high-growth companies is partly due to their innovative potential and dexterity in adopting sustainable practices. However, these firms are typically more cyclical, meaning their performance is closely tied to economic cycles. During periods of economic expansion, small and mid-cap growth stocks tend to outperform due to increased investor risk appetite and robust earnings growth. Equally, during economic downturns, these stocks can be more volatile and underperform relative to larger, more stable companies. This cyclicality influences the performance trends in sustainable investing, aligning it with broader economic conditions and market sentiment.
Furthermore, sensitivity to market volatility mean that short-term focused investors are more likely to react to market volatility, potentially pulling out investments in response to short-term downturns. Sustainable investments, which require a patient capital approach, can suffer if investors do not commit for the long term.
This hypersensitivity and reactivity, correlate with psychological factors that impact on investment behaviour, one such factor being the need for immediate gratification. Human behaviour is often driven by the desire for immediate gratification and this psychological bias can deter individuals and institutions from committing to sustainable investments that require a longer-term perspective.
On 5th June 2024, at the Future Investment Festival, Dr Greg Davies, Head of Behavioural Finance at Oxford Risk, gave an extremely interesting talk that examined the anxieties and fears of investors, and the gap between expectations and the actual future. Using data and evidence he explored how attitudes are changing, what investors genuinely care about, and how to avoid letting short term anxieties lead to harmful investment behaviour.
Dr Davies highlighted that people love seeing patterns , but more often than not we are wrong, yet we maintain emotional attachment to our view point. He argues that actually when it comes to investment, what really matters is how long you can hold it, and that we should put our wealth to work and ‘leave it alone’. If you are a long-term investor you should be invested, but people don’t live in this long term. This emotional decision-making costs 62% of clients more than 100bps a year (Dr Davies believes the true figures are much higher). Further statistics provided revealed, 80% of advisers think they have a good understanding of their client’s psychological profiles, but 80% are also purely relying on their intuition for this awareness,68% of these advisers then report being ‘surprised’ by their client’s decision making.
If you look at rolling 10 year investment horizon versus a rolling 12 month horizon, the picture is vastly different. Therefore, it is counterproductive to look at the time horizons that you are not trying to achieve and react to them. Dr Davies likened this to the Sirens of Greek and Roman mythology, who were fabled to have lived on an island and to have lured sailors to their deaths in dangerous waters with their irresistible song.
Where standard client assessment involves purely looking at risk tolerance, Dr Davies highlighted that it would be more holistic and beneficial to also assess emotional composure and confidence as well. Advice can therefore be hyper personalised and you can put the right message in front of the right person to optimise client outcomes, rather than them losing out due to emotional reactivity and the ‘Sirons’.
So how do we overcome Short-Termism for Sustainable Investing?
To break through these barriers, certain steps need to be taken, beginning with education. We need to increase the awareness about the long-term benefits of sustainable investing, which can help shift investor focus from chasing short-term gains, and to focusing on long-term value creation instead.
Addressing short-termism is crucial for the growth and success of sustainable investing; as it requires a shift in mind set from immediate financial returns to long-term value and impact. But it also requires sustainable investment to be much better understood. Overall, adviser unfamiliarity on sustainable investment can significantly prevent investors from accessing sustainable investment products, for several reasons.
Firstly, if financial advisers lack knowledge about sustainable investment options, they are less likely to recommend these products to their clients. Many advisers might not be familiar with the various ESG (Environmental, Social, and Governance) factors, sustainability metrics, or the performance history of sustainable investments. An absence of adequate training on sustainable investing can result in a lack of confidence or reluctance to discuss and recommend sustainable investment products to clients. Without a good understanding of how sustainable investments perform, advisers might struggle to accurately assess and communicate their potential benefits and risks to clients.
Sadly, client demand misjudgement is also a big issue, where advisers might underestimate the level of interest their clients have in sustainable investments. If they assume clients are primarily interested in short-term returns, they may not even bring up sustainable options. A lack of proactive communication about sustainable investment opportunities means clients might remain unaware of these options, even if they are interested in aligning their investments with their values. This links back to the study discussed by Dr Davies, where advisers were relying on their intuition to know about their clients, but then being surprised by their decision outcomes.
Investors do indeed care about sustainability, and the percentage of investors who care has been increasing in recent years. Various surveys and studies evidence a growing interest among different types of investors in sustainable investment options. Below are some key statistics / findings to evidence this, and highlight the disparity between advisers’ assumptions and investor’s true interest:
Morgan Stanley Institute for Sustainable Investing (2021):
Retail Investors: 79% of individual investors were interested in sustainable investing, with Millennials showing the highest interest at 99%.
Institutional Investors: 85% of institutional investors were interested in sustainable investing, with many integrating ESG factors into their investment processes.
Morningstar (2020):
General Interest: A survey showed that over 72% of the global population was interested in sustainable investing, reflecting a broad-based interest across different demographics and regions.
EY Global Institutional Investor Survey (2020):
Institutional Investors: 98% of institutional investors surveyed indicated that they conduct a formal or informal review of ESG factors as part of their investment strategy.
UBS Investor Watch (2021):
High Net Worth Investors: 78% of high net worth investors (with at least $1 million in investable assets) expressed interest in sustainable investing, with a significant number already having allocations to sustainable investments.
Schroders Global Investor Study (2022):
Global Investors: 68% of investors surveyed globally considered sustainability factors important when making investment decisions, with younger investors (Millennials and Gen Z) showing a higher inclination towards sustainable investing.
Moreover, this interest will continue to grow due to inter-generational wealth transfer which will ultimately benefit sustainable investment, as younger generations are more inclined to invest sustainably.
The time frame for intergenerational wealth transfer to significantly impact sustainable investment assets under management (AUM) can be understood through several key phases and trends. It’s important not to let short termism rear its head again, where advisers that cannot see an immediate consequence to wealth transfer dismiss it as not happening, or hype. For perspective let’s look at the Wealth Transfer Timeline:
The majority of the wealth transfer from Baby Boomers to Millennials and Generation X is expected to occur over the next two decades. According to various estimates, trillions of dollars will be transferred during this period. According to Cerulli Associates, an estimated $84.4 trillion in wealth will be transferred across generations in the United States by 2045. This substantial transfer includes $72.6 trillion in assets that will go to heirs and $11.9 trillion that will be donated to charities. The majority of this wealth, about $53 trillion, will come from Baby Boomer households (ThinkAdvisor) (Cerulli Associates).
Over the immediate to short-term (1-5 years), when Millennials and younger generations start receiving this wealth, there is going to be an uptick in sustainable investments. We have seen that these generations show a stronger preference for ESG (Environmental, Social, and Governance) and sustainable investment strategies compared to older generations.
The medium-term (5-10 years)impact will become more pronounced as a larger portion of the wealth transfer is completed, and these younger investors gain more financial influence. Investments firms that are not already prepared are likely to need to adjust their offerings to cater to this growing demand.
Economic and Social Factors affect investment across all time spans, short to long-term (1-20 years). Here factors such as climate change, social justice movements, and technological advancements in sustainable solutions will further influence investment decisions. Younger generations are more familiar with these issues, and will likely push for investments that align with their values. Overall, the shift towards sustainable investment AUM driven by intergenerational wealth transfer will likely span the next 20 years, with the most significant impacts visible in the medium to long term.
Advisers who are not well-versed in sustainable investing might not be aware of the full range of available sustainable investment products to offer this growing interest and investment requirement. This can limit the options they present to their clients, effectively restricting access. They may also have compliance concerns, and be apprehensive about meeting fiduciary duties and regulatory compliance when recommending sustainable investments, particularly if they are not well versed about how these products align with clients' financial goals and risk tolerance.
Advisers should actively engage with clients to understand their values and preferences regarding sustainability, and proactively discuss sustainable investment options with clients. This should happen even if clients do not initially express interest, as this enables clients to become aware of opportunities they might otherwise overlook.
In terms of regulation, a concept that is not well understood is that Consumer Duty and Sustainability, especially within SDR, are not mutually exclusive. A client’s sustainability goals and preferences should be ascertained as part of suitability assessment and as part of their outcomes. It’s not good enough to avoid the topic if an adviser doesn’t have the necessary knowledge. Such a response is not in the clients best interests or compliant with regulation.
In conclusion, reaping the benefits of sustainable investing, both in financial terms and for addressing global issues that affect us all, requires flexibility in thinking and a more holistic and pragmatic lens in which to analyse investment, rather than an over reliance and focus on short term. This needs to be facilitated through raising awareness of sustainable investing, its features and the products available. If we don’t adapt and embrace sustainable investing over the medium to long term, we are likely to lose clients who will want to find investment solutions that understand and align with their values.