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Sustainable Index Funds Could Be the Next Big Thing

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·6 min read
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The current economic recession in the U.S. could lead to massive changes in how businesses operate in the future. In the past, economic downturns proved to be disastrous for all business sectors alike. This time around, though, a certain set of companies have weathered the storm better due to the nature of their business operations. For instance, online-oriented companies such as Amazon.com Inc. (NASDAQ:AMZN), Netflix Inc. (NASDAQ:NFLX) and Zoom Video Communications Inc. (NASDAQ:ZM) have turned the dire economic conditions into an opportunity to gain traction. This characteristic will likely lead to dramatic changes in corporate America. The varying impact of the recession is not limited to the financial performance of companies. The investing landscape could also experience dynamic changes as a result of this economic collapse. Sustainable investing is an asset class that could benefit in the long term as a result of these changes.

The soaring popularity of sustainable investing

Sustainable investments have grown exponentially since 2012 as investors, economists, analysts and governments have shown a preference to investing money not only to maximize returns, but also to achieve socially accepted values. Companies, on the other hand, have been forced to adopt measures to address adverse developments that could harm society in general. Collectively, these factors have attracted billion-dollar investments since the fallout of the financial crisis.

Source: BlackRock.

One of the most important questions is whether these investments are generating attractive returns in comparison to traditional investment vehicles.

Sustainable funds outperformed their traditional peers in the first quarter

Under normal market conditions, investors expect high-growth companies to deliver the best returns. However, when searching for such multi-baggers, it's easy to lose focus and bet on companies that achieve growth through unsustainable measures. In such instances, the value of a portfolio is destined to decline drastically when an external force disrupts the market. This is exactly what has happened this year.

Morningstar Research conducted an extensive study into the performance profiles of sustainable and conventional funds in the first quarter to determine which kind of funds are weathering the storm better. They found:

"Sustainable index funds are designed as alternatives to conventional index funds across equity markets. Based on a comparison of 26 sustainable index funds with those of conventional index funds covering U.S. stocks, non-U.S. developed-markets stocks, and emerging-markets stocks, 24 of them outperformed the comparable conventional index fund."

According to the published data, 44% of sustainable funds ranked in their category's best quartile, indicating the overall success of this strategy.

Source: Morningstar.

One of the primary drivers of this success was the relatively low exposure of these funds to the energy sector. In the first quarter, oil and gas stocks fell sharply as a result of the massive decline in demand for energy products. The high exposure to the information technology space also played a role as it was one of the best-performing sectors in the first three months of this year.

The best way to invest in companies that embrace sustainable growth principles

For investors, finding companies that adhere to environmental, social and governance principles could be a difficult task. They would need to dig deep into the financials of a company to gain an accurate understanding of its business practices and, even then, there's no guarantee of success in this endeavor. The best option, therefore, is to gain exposure through an exchange-traded fund that specializes in sustainable companies. This will help investors improve the diversification of their portfolios as well because the fund would be investing in several companies as opposed to just one.

Below is a list of funds investors can choose from to match with their investment objectives, risk tolerance and time horizon.

U.S. sustainable equity funds

Developed ex-U.S. sustainable equity funds

Emerging markets equity sustainable funds

iShares USA ESG Select ETF (SUSA)

Green Century MSCI International Index (GCIFX)

Nuveen ESG Emerging Markets Equity ETF (NUEM)

iShares MSCI KLD 400 Social ETF (DSI)

Calvert International Responsible Index (CDHIX)

Xtrackers MSCI ESG Leaders Equity ETF (EMSG)

Fidelity U.S. Sustainability Index (FITLX)

Nuveen ESG International Equity ETF (NUDM)

iShares ESG Emerging Market ETF (ESGE)

Vanguard ESG U.S. Stock ETF (ESGV)

Vanguard ESG International Stock ETF (VSGX)

In the post-recession era, investment analysts are likely to attach premium valuation multiples to companies that adhere to ESG principles as many of these companies have shown resilience in the last few months. On the other hand, it could bring this investment class to the main street as investors finally realize that these opportunities can generate attractive returns as much as a conventional investment could.

Takeaway: secular growth of sustainable investing can be expected in the post-recession period

When it comes to investing, it's often beneficial to identify developing trends early. Investment techniques and asset classes that provide the best returns over a five-year period might fail to deliver attractive returns in the following five years. For example, cable-TV operators delivered stellar returns to investors from 2000 to 2010, but streaming platforms such as Netflix have pushed these once booming companies into a corner over the last several years, leading to disappointing returns. The secular growth of passive investing strategies is another classic example as many of these funds have provided better returns than actively managed funds in the last decade.

Today, sustainable investing is gaining popularity as a strategy that can be relied upon to deliver better returns in comparison to traditional investments when a catastrophic market event occurs. The outperformance in the first quarter will be a wake-up call for portfolio managers to allocate a portion of their clients' assets to sustainable industries in a bid to lower the correlation with the broad market.

Surprisingly, these strategies have proven their ability to deliver acceptable returns since 2006, but many investors did not notice this until recently. From 2006 to 2018, the MSCI All Country World Index (ACWI) generated lower returns than the Corporate Knights Global 100 Index, which is a proxy for the best global companies that focus on sustainable business operations.

Source: Visual Capitalist.

Now that these funds are getting attention from institutional investors, retail investors can focus on gaining exposure to this booming asset class by investing through an exchange-traded fund.

Disclosure: I do not own any stocks or funds mentioned in this article.

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This article first appeared on GuruFocus.