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Investors look for more diversification, transparency and innovation in ESG solutions amid unsettled markets

Rising volatility and a shift in markets this year have highlighted the shortcomings of some environmental, social and governance (ESG) investment strategies. A rotation in market leadership away from stocks valued for their growth potential to stocks with more reliable and durable income has particularly hurt ESG funds with a growth bias or that are narrowly focused on a single theme.

But these pockets of underperformance have not significantly diminished investor interest in ESG. Diversified ESG solutions that provide tangible real-world impact are still in demand. Investors are calling for greater innovation in the ESG space.

These were just some of the key insights revealed in the second installment of Capital Group’s ESG Global Study^[1]. The annual survey gathers the views of more than 1,100 professional investors across the globe. While the first chapter focused on the key drivers of ESG adoption, the second installment drilled deeper into investors’ product preferences, and the insights have proved revealing.

Demand for ESG products that address multiple themes

The study showed strong investor appetite for funds that provide exposure to multiple ESG themes. However, there remains a gap between investor demand and the availability of such offerings.

Using the UN Sustainable Development Goals (SDGs) as a framework to calibrate ESG themes, investors indicated that many funds are too heavily focused on environmental issues. Furthermore, despite an appetite for SDG-aligned strategies, investors said there is a lack of choice when it comes to products. Often these solutions can be too narrowly focused and don’t provide exposure to the full spectrum of sustainability issues.

Appetite for broader ESG solutions may reflect a desire to steer away from funds with a quality and growth bias^[2] – styles that have suffered amid the inflation-fueled rotation to value strategies experienced earlier this year. Addressing a range of sustainable priorities through ‘all-in-one’, multi-thematic investment vehicles could potentially help deliver smoother and more consistent returns.

Investors highlighted that adapting to changing market conditions and better withstanding volatility could be a challenge for ESG funds, as some narrowly focused ESG funds may be more susceptible to volatility, as holdings can be concentrated among a relatively small group of companies. Three in 10 global investors say greater volatility of returns is a hallmark of ESG funds and point to less diversification as a characteristic of these strategies.

Transitioners key to solving the climate crisis

The study also showed that views among the investment community are evolving. There is growing acceptance that a sustainable future cannot be achieved solely by supporting companies considered to be the ESG leaders. In fact, one third (34%) agree that asset managers investing solely with ESG leaders at the expense of so-called “transitioners” are doing more harm than good.

A portfolio manager at a US registered investment adviser (RIA) said:

“I think there’s a place for both – those companies that are already ESG friendly and those that clearly have a mandate to become more ESG friendly.”

Many investors globally recognise the need for a multi-pronged approach to climate change and are set to adjust portfolios accordingly.

Importantly, an approach that focuses on ESG transitioners as well as leaders also could make sound investment sense. Companies with poor ESG ratings that are able to raise their scores and improve their sustainable credentials may see this reflected in their valuations.

Portfolios including both ESG leaders and transitioners also benefit from greater diversification by virtue of holding companies in different sectors and at different stages of growth. With investors concerned about the level of diversification in ESG funds, constructing portfolios with both ESG leaders and transitioners could help overcome these concerns.

Greater innovation to boost ESG adoption

More broadly, investors have called for more expansive innovation across ESG solutions. Almost four in 10 (39%) global investors think a lack of product innovation is holding back greater adoption of ESG.

Providing access to thoughtfully constructed diversified portfolios, based on a credible framework, could encourage non-adopters to enter the ESG space and boost take-up.

Credibility is key. Among the biggest challenges preventing investors from increasing their ESG focus are transparency and consistency in ESG fund reporting. In fact, more than 50% of global investors identified impact reporting and increased transparency as a defining feature of sustainable solutions. Improving transparency would also add credibility to ESG solutions. One portfolio manager of a Canadian pension fund commented:

“We’ve seen some asset managers with a longstanding fund just add an ESG angle to it, but there has been no change of direction whatsoever.”

Products with transparent reporting frameworks that can clearly explain how the underlying investments are working to promote real world sustainable development would be welcomed by many investors.

Insights from the study confirm that investors want to make a difference through their ESG investments. However, more innovation across the industry is needed. All-in-one, fully diversified solutions that allow investors to target multiple goals through one fund could not only increase the potential for long-term financial and sustainable returns, but also boost ESG adoption.

For a more detailed look at investors’ ESG product preferences, read the second installment of the ESG Global Study here.

 

[1] All survey data throughout this article is from the Capital Group ESG Global Study 2022: Chapter 2.

[2] Stocks with a growth bias are those considered to have strong future potential. Quality stocks are those considered financially sound with strong balance sheets and stable growth.