Sustainable investment is booming. After a year of phenomenal growth in 2020, sustainable funds attracted more than half of European fund flows in Q1 2021, with AUM reaching a record €1.3 trillion, according to Morningstar. Such strong investor demand has fuelled an explosion of sustainable fund launches, with a further 111 in Europe in Q1 alone. This proliferation of funds represents a great opportunity for fund selectors, but a lack of consensus around both the concept and measurement of sustainability brings fresh challenges when assessing performance potential within a multi-manager portfolio.
A disparate universe
With few formal definitions, sustainable and ESG labels are often used indiscriminately, encompassing a vast array of approaches and strategies, from simple negative screening to impact investment. To add to the confusion, in some cases, ‘new’ funds are simply existing strategies that have been repackaged, perhaps with a few tweaks around the edges to fit the least onerous interpretation, and whose sustainable credentials are questionable.
Assessment of ESG factors is integral to sustainable investment, yet there is little agreement on how to do it – a study by MIT Sloan found that correlation among the ESG ratings of five leading providers was on average just 0.61. This gives rise to the risk that managers can cherry-pick the rating agency or benchmark whose approach offers the best results at the time. ESG ratings are of course not just dependent on the provider’s methodology, but also on the quality and availability of company data, which at present remains inconsistent, incomplete, and often voluntary. The industry is working hard to reach an agreement on sustainability reporting, but for now, it remains a vast alphabet soup of different standards with limited comparability.
This lack of clarity around definitions and ratings is important because they shape not only the design of an investment strategy but also how its performance is measured. The number of ESG indices has soared in recent years, offering increasingly nuanced ways to invest and benchmark performance. Bespoke benchmarks can be useful for assessing individual manager skills, but if each manager uses a different approach, how can you compare them using a universal measure when building a portfolio of funds?
Tweaking the research process
Rather than potentially waiting years until global reporting standards and definitions are agreed upon, it is imperative that we find a way to cut through the noise and make informed decisions. With a few adjustments to the research process, the solution may be less complex than it sounds. As fund selectors, we all have different ways to conduct our due diligence but, explicitly or not, and regardless of how we may claim to be unique, we tend to go through the same four steps when assessing a strategy: mapping, measuring, modeling and monitoring.
First, we analyse a manager’s approach, mapping everything from their chosen asset class to the inefficiencies they aim to capture. Next, we assess how successful they have been and how confident we are that they will deliver on their approach going forward. This step traditionally involves the use of specific benchmarks and measures of risk and return that are relevant to the asset class and investment styles, such as tracking error or active share. We then build a model, developing a portfolio profile for each strategy as well as an expected performance path i.e. a prediction of how it is likely to perform in different market conditions. Finally, we monitor that each strategy’s performance unfolds as expected, and within its constraints and characteristics.
One of the strengths of this framework is that it allows for an amazing level of specificity when analysing asset managers. After years of client/consultant/manager collaboration, there is the right benchmark/measure combination to suit almost every strategy. In the current situation, however, with the lack of standardised sustainable benchmarks and faced with such a fast-growing heterogenous fund universe, we need to adjust the focus and zoom out.
Finding a common metric
Given the confusion and disparity in the industry, it makes sense to step back and use the widest-reaching measures of risk-adjusted return as possible. Without standardisation, we need to avoid focusing on overly specific, potentially misleading benchmarks and keep it simple by trying to identify which managers are likely to give us the best bang for our buck. Using Sharpe and Sortino ratios to measure manager performance, regardless of their strategy or approach, helps us compare them using a common language, a particularly useful needle in today’s sustainable investment market haystack.
I get a wide array of reactions, ranging from surprise and amusement to condescension and even anger, when I explain that the Sharpe ratio of a manager is our main measure of performance success. But I have no doubt that between two managers who stick to their portfolio profile and predicted performance path, as established in the due diligence, the one with the higher Sharpe ratio is extremely likely to have been the one with the greater skill.
The Sharpe ratio is a blunt (ironically), but extremely useful tool, which allows us to make fast comparisons not only between different performance profiles, but also across investment styles and asset classes. It enables us reach conclusions, even in the absence of any specific benchmark, therefore making it extremely well suited to the current conditions.
But that is only half the story…
This solution only addresses the issue of performance in terms of investment return. The other, equally important, and yet more complex aspect of sustainable investment is impact. There is no fast ‘hack’ to assess this side of performance, but that, as they say, is another story (and one that is coming this way soon).