Will Sustainable Investing Affect my Returns & Increase my Costs?
At Everlake we believe investment returns are explained by the following investment decisions: asset allocation, diversification, and investment approach.
1. Asset Allocation
Asset allocation is how much of your portfolio is invested in different investment types, or asset classes; equities, bonds, and short-term investments, as well as ‘real assets’ like real estate or commodities.
About 90% of investment performance is due to asset allocation. The pie chart below illustrates a typical investment asset allocation.
The recent flows of money coming into Sustainable Investing have provided for sustainable options in each of the asset classes outlined in the pie chart above.
Diversification in your portfolio reduces stock specific risk.
Individual stock specific movement may not be predictable. A diversified portfolio should expect to have some investments going down from time to time and some going up. They tend to cancel one another out and if all the movements are going in one direction, your portfolio is not diversified.
There is a material difference between sustainable portfolios and traditional market portfolios due to two factors:
- Concentration of stocks. When we apply strict sustainable criteria to the number of global stocks (circa 12,000) the numbers can drop to as little as 400 stocks. This results in a higher degree of concentration compared with a traditional market portfolio. There is no evidence that this concentration leads to lower long-term outcomes, but does increase short term volatility.
- Profile of companies. Companies are generally classified by two main criteria: Size of Corporations (measured by share capitalisation) and Stock Characteristics (measured by expected future earnings).
Size of Corporations
Stocks can be categorised by size.
- Large-cap corporations – typically a substantial proportion of the global stock market with market capitalisations of US$10 billion+. They tend to be more mature companies, grow slower than smaller companies, but are also expected to be less volatile.
- Mid-cap corporations - the next tier are mid-cap stocks, those with capitalisation between $2 and $10 billion. These tend to have more aggressive growth than large cap companies.
- Small-cap corporations – the smallest, they have capitalisation between $300 million and $2 billion. These stocks are cheaper and more affordable for investors but are significantly more volatile than larger cap companies.
Sustainable Portfolios tend to prioritise stocks that are newer (medium and small cap). A portfolio of small stocks tends to have a higher return over the longer term, but higher volatility in the shorter term.
Sustainable investments often differ from traditional investments based on stock styles known as growth or value.
- Growth stocks - analysts consider growth stocks to have the potential to outperform either the overall markets or else a specific sub-segment of them for a period of time.
- Value stocks - generally trade below what they are really worth and therefore have a higher expected return. They tend to be mature businesses that pay strong dividends to investors.
Small, mid, and large-cap sectors can all contain growth stocks, but they can only remain in this category until analysts believe they have fulfilled their potential.
Sustainable Portfolios tend to prioritise stocks that are newer (medium and small cap) and more future growth focussed.
3. Investment Approach & Impact on Cost
Investors can use different management strategies to generate a return on their investment accounts, described as ‘active’ or ‘passive’ portfolio management.
- Active portfolio management focuses on attempting to outperform the market in comparison to a specific benchmark such as the MSCI World Index, by using a stock selection or marketing timing strategy.
- Passive portfolio management mimics the investment holdings of a particular index in order to achieve comparable results to the index. There is no attempt to outperform the benchmark.
When sustainable impact is the focus, the funds chosen tend to be actively managed funds. This active management style is the most significant factor in increasing the costs associated with sustainable investing.
Active managers in the sustainable field incur significantly more cost to operate as their processes involve a much deeper analysis of a particular stock, bond, or any asset.
A passive fund on the other hand can buy data and apply this data to which companies they invest in without having to employ more resources to screen and engage each company.
Active management costs on average 0.71% for an equity fund, compared to only 0.06% for the average passive equity fund.
The costs need consideration from investors as there is no evidence that additional fees will lead to additional performance. Therefore, sustainable investors may need to accept lower returns for their preferred investment style.
The risk profile and sequence of returns may be different. The implications are that your performance from time to time will look different to the market.
Learn more about Sustainable Investing DOWNLOAD OUR GUIDE
Read more here Are Sustainable & Impact Portfolios Worth The Price?
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