Performance paradox

As avid readers will know, Infradebt held the first close of its ethical fund (IEF) in September last year, and with that disclosure I promise the rest of this article doesn’t include any gratuitous self-promotion!

In the lead up to launching our fund, we did a lot of research into the ethical investment space. This included looking at the different ethical funds offered by fund managers as well as the range of ethically or sustainability screen investment choices that large superannuation funds are offering to members.

Out of this research, a paradox emerged.

  1. Specialist Australian ethical managers are showing strong long-term relative performance. For example the RIAA Performance Benchmarking Report (2017) shows 10 year performance of Australian responsible investment funds of 6.3% per annum over 10 years compared to the benchmark of 4.4% or a Morningstar index of mainstream funds of 3.8%. This is almost 2% of additional performance over a decade.

  2. SRI/Ethical options of large not for profit superannuation funds often underperformed their Balanced/MySuper equivalent within the same fund. For example, Infradebt looked at the performance 14 large funds that have SRI/Ethical options. For those funds with 5 year performance records for both the SRI/Ethical option and the mainstream balanced option, 9 out of 10 funds had the SRI/Ethical option underperform their internal peer. Looking at the longest dataset across all funds, in 70% of cases the SRI/Ethical option underperformed.

I would admit that our sample isn’t particularly scientific (there are probably more than 14 funds out there), but it is a reasonably large sample and over quite a significant time period. Furthermore, it doesn’t make sense that the balanced SRI/Ethical options should underperform, when these strategies would seem to be outperforming within the largest underlying asset class (Australian equities).

This raises the question of why?

It may be a quirk of timing – SRI/Ethical strategies often involve significantly different sector allocation to the index (for example, lower exposure to resource stocks) and this can drive big divergences in performance. However, it might equally point to a more systemic issue. If so, what are potential explanations. Here are my thoughts (hypotheses if you will, as I have no underlying analysis to back them up):

  • Fees. Many SRI/Ethical options have higher fees than the balanced/default option in the same fund. This is a reflection of scale (these options will have smaller mandates than the main portion of the fund) as well as potentially a reduced use of indexed management.

  • Reduced allocations to private market assets (Property, Infrastructure, Alternatives). SRI/Ethical options often have less exposure to these asset classes. This can be driven partly by genuine underlying SRI/ethical issues – for example, many infrastructure asset classes – such as fossil fuel fired electricity generation – involve very high emissions. But it also can arise from the nature of pooled management structures, which can make it difficult for the SRI/Ethical option to get exposure to the “good” assets within a funds broader infrastructure/alternatives portfolio (i.e. simplistically the “good” and “bad” assets are mixed together). This might see SRI/Ethical options having lower private markets asset exposure, and in the same way retail funds have shown persistent underperformance compared to industry funds, this could adversely impact relative performance.

  • · Fixed income. With my first sentence disclaimer at the front of your mind, one of the other potential issues is that fixed income portfolios for SRI/Ethical options might end up with a greater allocation to government bonds and very highly rated corporates (as the issuers of Green Bonds are disproportionately from the very low risk end of the credit spectrum) and a lower exposure to credit (which offers higher returns).

  • Implementation/Leakage. The final possible explanation is that traditional balanced options get a benefit from being much larger than the typical SRI/Ethical option. It could be that it is the little things – rebalancing, cash flow management, transaction cost and tax optimisation, persistently add up to the benefit of the larger multi-asset investment choices (although this issue would presumably apply equally to other non-default choices like conservative and high growth options).

It is difficult, without a lot of underlying performance data, to get to the bottom of this issue – and it is also important to remember that the drivers of performance will be different for different funds. However, from Infradebt’s perspective it should be possible to deliver superannuation member investment choices that are ethical and sustainable and don’t involve a sacrifice in investment performance.

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At Infradebt we are not tied to investment labels. At the end of the day, all investing is investing. We believe the most important thing is a laser like focus on risk vs reward trade-offs, and unders