With Leonardo DiCaprio raising awareness on climate change, Emma Watson advocating for gender equality and Matt Damon co-founding a company to address water scarcity, sustainability has gone mainstream. So what has prevented this movement from extending further into the financial markets?
Let’s first look at what sustainability looks like in financial terms. In sustainable investing, the ideal scenario is when you find opportunities that produce the highest returns and have the highest positive impact.
However, more often than not, there is a tradeoff to be made. On one end of the spectrum, sustainable funds can be philanthropic, or impact-driven, meaning the fund will be maximizing for impact subject to profits. Conversely, hedge funds that integrate non-financial sustainability metrics into their investment framework will be seeking to maximize profits and fulfill their fiduciary duty subject to impact. Here, the byproduct is better risk-adjusted returns by incorporating more relevant information.
Going back to the question of why sustainability hasn’t made greater strides in financial markets, it’s helpful to look at how a movement becomes successful. To begin and persevere a movement that effects real change, it needs not only leaders, but even more importantly, those first followers who can draw momentum to the movement to achieve critical mass. At that juncture, the comfort of being among the skeptics has shifted to being among the believers. Those who do not want to stand out will conform to the change, and the body of followers grows exponentially. Derek Sivers points to the famous “Sasquatch Music Festival 2009” video for a visual representation of that movement.
As simple as that methodology for change looks on paper, the truth is that social movements take considerable time and the removal or leapfrogging of many obstacles. Financial markets have been around for hundreds of years, so prior notions and dispositions need to be challenged. This initial work has been performed by funds such as Generation, Impax and Parnassus. They broke the status quo and proved to the markets that sustainable investing can be a significant part of investing’s future, in the 21st century and beyond. Further, early adopters have joined those leaders to establish the movement as a reckoning force. However, to truly enact a sustainable and permanent change, the most significant obstacle still must be removed — the concentration of assets under management.
At the end of 2017, sustainable investing accounted for around $12 trillion in U.S. assets, a drop in the bucket compared to the total $263 trillion invested in the global public markets, according to World Bankand IMF data, and accounting for a penetration of approximately 4.5%. Much like the move toward electric vehicles, financial market incumbents must maintain their current offerings while slowly pivoting resources toward the future. On the other hand, incipient funds do not need to migrate resources, as their investment process and research and development are entirely focused on this new frontier. However, these smaller funds currently lack the reputation or scalability to make a larger dent in the financial markets, so there is an opportunity for the larger, incumbent funds to empower smaller firms giving rise to this group of early adopters that will drive change in a larger scale.
How can these large, multibillion-dollar funds help this process along to create more sustainable returns for their investors, along with a more sustainable world for future generations? As those incumbent firms grow larger, their capacity to provide higher returns diminishes, their asset allocation shifts to higher liquidity assets and their impact is smaller than when they first started. By partnering with new firms, they could generate a win-win-win situation: By allocating money to new smaller sustainable managers, they can increase their overall returns, provide the emerging managers with the reputation and name recognition to raise additional assets, and increase societal impact not just through investments, but also by creating an ecosystem of sustainable investment firms.
Early adopters are vital to effect real change, and innovators should embrace early adopters by empowering them, be it through incubators, separately managed accounts, direct investments or some other way. If we can achieve that, we might have a chance at making sustainable investing mainstream.
